Fund Formation Attracting Global Investors - Nishith Desai

Research

October 2020

Fund Formation:Attracting Global Investors

Global, Regulatory and Tax Environmentimpacting India focused funds

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© Nishith Desai Associates 2020

October 2020

Fund Formation: Attracting Global Investors

Global, Regulatory and Tax Environment impacting India focused funds

DMS Code: #565,364




About NDAWe are an India Centric Global law firm (www.nishithdesai.com) with four offices in India and the only law firm

with license to practice Indian law from our Munich, Singapore, Palo Alto and New York offices. We are a firm of

specialists and the go-to firm for companies that want to conduct business in India, navigate its complex business

regulations and grow. Over 70% of our clients are foreign multinationals and over 84.5% are repeat clients. Our reputation is well regarded for handling complex high value transactions and cross border litigation; that

prestige extends to engaging and mentoring the start-up community that we passionately support and encourage.

We also enjoy global recognition for our research with an ability to anticipate and address challenges from a

strategic, legal and tax perspective in an integrated way. In fact, the framework and standards for the Asset

Management industry within India was pioneered by us in the early 1990s, and we continue remain respected

industry experts.

We are a research based law firm and have just set up a first-of-its kind IOT-driven Blue Sky Thinking & Research

Campus named Imaginarium AliGunjan (near Mumbai, India), dedicated to exploring the future of law & society.

We are consistently ranked at the top as Asia’s most innovative law practice by Financial Times. NDA is renowned

for its advanced predictive legal practice and constantly conducts original research into emerging areas of the law

such as Blockchain, Artificial Intelligence, Designer Babies, Flying Cars, Autonomous vehicles, IOT, AI & Robotics,

Medical Devices, Genetic Engineering amongst others and enjoy high credibility in respect of our independent

research and assist number of ministries in their policy and regulatory work. The safety and security of our client’s information and confidentiality is of paramount importance to us. To this

end, we are hugely invested in the latest security systems and technology of military grade. We are a socially

conscious law firm and do extensive pro-bono and public policy work. We have significant diversity with female

employees in the range of about 49% and many in leadership positions.


Provided upon request only

Accolades

A brief chronicle our firm’s global acclaim for its achievements and prowess through the years –

§ IFLR 1000 India Awards 2000: Private Equity Deal of the Year award for acting as the fund counsel and deal

counsel for NIIF while raising from Australian Super and OTPP.

§ Benchmark Litigation Asia-Pacific: Tier 1 for Government & Regulatory and Tax 2020, 2019, 2018

§ Legal500: Tier 1 for Tax, Investment Funds, Labour & Employment, TMT and Corporate M&A 2020, 2019,

2018, 2017, 2016, 2015, 2014, 2013, 2012

§ Chambers and Partners Asia Pacific: Band 1 for Employment, Lifesciences, Tax and TMT 2020, 2019, 2018,

2017, 2016, 2015

§ IFLR1000: Tier 1 for Private Equity and Project Development: Telecommunications Networks. 2020, 2019,

2018, 2017, 2014

§ Asia Law Asia-Pacific Guide 2020: Tier 1 (Outstanding) for TMT, Labour & Employment, Private Equity,

Regulatory and Tax

§ FT Innovative Lawyers Asia Pacific 2019 Awards: NDA ranked 2nd in the Most Innovative Law Firm

category (Asia-Pacific Headquartered)

§ RSG-Financial Times: India’s Most Innovative Law Firm 2019, 2017, 2016, 2015, 2014

§ Who’s Who Legal 2019: Nishith Desai, Corporate Tax and Private Funds – Thought Leader

Vikram Shroff, HR and Employment Law- Global Thought Leader

Vaibhav Parikh, Data Practices - Thought Leader (India)

Dr. Milind Antani, Pharma & Healthcare – only Indian Lawyer to be recognized for ‘Life sciences Regulatory,’

for 5 years consecutively

§ Merger Market 2018: Fastest growing M&A Law Firm in India

§ Asia Mena Counsel’s In-House Community Firms Survey 2018: The only Indian Firm recognized for Life

Sciences

§ IDEX Legal Awards 2015: Nishith Desai Associates won the “M&A Deal of the year”, “Best Dispute

Management lawyer”, “Best Use of Innovation and Technology in a law firm” and “Best Dispute

Management Firm”




Please see the last page of this paper for the most recent research papers by our experts.

DisclaimerThis report is a copy right of Nishith Desai Associates. No reader should act on the basis of any statement

contained herein without seeking professional advice. The authors and the firm expressly disclaim all and any

liability to any person who has read this report, or otherwise, in respect of anything, and of consequences of

anything done, or omitted to be done by any such person in reliance upon the contents of this report.

ContactFor any help or assistance please email us on [email protected]

or visit us at www.nishithdesai.com

AcknowledgementsAfaan [email protected]

N. [email protected]

Parul [email protected]



Dear Friend,

As the world comes together digitally while combating with the ongoing COVID-19 pandemic (which started

early in 2020 in India), private equity (PE) and venture capital (VC) fund managers have also resumed their

raising and investment activities. In the early months of the pandemic, it was predicted that fund managers

will focus on their existing portfolio and stay clear of being aggressive on new investments (or raising new

capital). With an attempt by the Indian economy to achieve steady adjustments, fund managers have also started

seeking opportunities in the face of this crisis – focusing on distressed assets, credit opportunities, infrastructure,

healthcare, telecommunication to name a few.

Recent developments Impact investing has become the name of the game in recent times, and is considered an important metric in

assessing the performance of funds across various sectors and industries, rather than being looked at as a distinct

class or strategy. To attract sophisticated LPs, fund managers or ‘General Partners’ (GPs) are now expected to follow

responsible investment regimes, and show impact of the investments in quantifiable terms.

One of the other important developments is introduction of beneficial ownership rules requiring approvals from

the Indian Government (Government) in case of foreign direct investment by any entity from China and other

countries neighboring India, regardless of the sector/activities in which investment is being made – in light of the

souring relationship between India and China.

Further, the Investor-State Dispute Settlement (ISDS) tribunal constituted under the India-Netherlands bilateral

investment treaty (BIT), has recently made a unanimous ruling in favour of Vodafone, in their dispute against

India. The tribunal ruled that in imposing the approx. INR 22,000 Crore tax liability on Vodafone, India was in

breach of its BIT obligation and has failed to provide ‘fair and equitable’ treatment to foreign investment. This

coupled with the fact that India has recently terminated a large number of its BITs, could be a cause of grave

concern to foreign investors, and may substantially impact large investments in infrastructure, manufacturing

and other sectors important to India.

Notwithstanding these developments, India continues to attract investments in the TMT, pharmaceuticals and

financial services sectors. Reliance Jio, the telecom and digital arm of Reliance Industries, has secured investments

amounting to over USD 20 billion in the past few months. Thus, India is an interesting mixed story for funds that

are strategy-driven.

New commitments and fund-raising related considerations

According to global LP surveys early in 2019, India was being seen as the most attractive emerging market for

allocating fresh commitments. While 2015 and 2016 saw a year-on-year decline in India-focused fund-raising,

this may have been due to renewed focus by GPs on deal-making given the dry-powder overhang. India has also

contributed to a rising trend of mega funds in Asia in 2017, with most of the PE funds aiming at larger fund sizes to

be able to accommodate the targeted ticket size deals. In line with the large fund raises, PE/VC investments in 2018

have substantially surpassed the previous high recorded in 2017 on the back of significant growth in large deals.

While LPs may repose more faith in repeat GPs in the current times, there is no dearth of LP allocation being

made to newer GPs as well. Attracted by favourable exit opportunities for technology-enabled companies—as

highlighted by high-profile strategic and public market exits for India-based technology-enabled companies in the

past few years, 63% of all LPs currently invest or plan to invest in technology opportunities in India, the highest

percentage of all emerging market geographies.




The investor appetite for India risk has been robust and that led to healthy fund raising for several tier 1 GPs with

track records. The fund-raising environment in 2017 (and continuing) has seen spurred efforts in India with the

regulatory reforms in foreign exchange laws with respect to onshore funds introduced in the last quarter of 2015

and tax certainty brought about by the protocols signed by India to its double taxation avoidance agreements with

various jurisdictions included Mauritius and Singapore. The regulatory changes are aimed at promoting home-

grown investment managers by allowing Indian managed and sponsored alternative investment funds (“AIFs”) with

foreign investors to bypass the foreign direct investment (“FDI”) Policy for making investments in Indian companies.

In 2019, India was among the top 10 recipients of the FDI attracting $49 billion in inflows, a 16% increase from

the previous year, driving the FDI growth in South Asia. The majority of the investment went into services

industries, including information technology. Similarly, investments from Foreign Portfolio Investors (“FPIs”)

in India significantly improved in 2019, after receiving the second-highest investments in the preceding five

years. The country received INR 1,35,995 crores as FPI investments in 2019. A major talking point in 2019 was

the attempt to impose increased surcharge or the ‘super-rich tax’ on FPIs functioning as trusts in India which was

eventually rolled back.

Regulatory changes

In 2019, SEBI has introduced the SEBI (Foreign Portfolio Investors) Regulations, 2019 (“FPI Regulations 2019”),

repealing the erstwhile SEBI (Foreign Portfolio Investors) Regulations, 2014 (“FPI Regulations 2014”). FPI

Regulations 2019 are supplemented by the Operational Guidelines which facilitate implementation of the FPI

Regulations (“Operational Guidelines”). The FPI Regulations 2019 read with the Operational Guidelines seem

to have consolidated the feedback from industry on the different circulars that had been issued by SEBI under

the FPI Regulations 2014. The FPI Regulations 2019 has done away with the 3 (three) categories of FPIs and

clubbed them into 2 (two) categories, which places increased reliance on whether the FPI applicant and/or its

investment manager is from a Financial Action Task Force (“FATF”) member country jurisdiction/s. Further,

the FPI Regulations 2019 has clarified that while resident Indians, non-resident Indians and overseas citizens of

India cannot apply for registration as an FPI, they can be stakeholders of an FPI applicant subject to fulfilment of

certain conditions and limits. Also, positively, the broad-based criteria, which many applicants were struggling to

achieve and maintain, has been done away with. The FPI Regulations 2019 permits issuance of offshore derivative

instruments (“ODIs”) or participatory notes (“P-notes”) by Category I FPIs and issuance of ODIs to persons

eligible for registration as Category I FPIs. This in effect means that an unregulated entity which is eligible to seek

registration as a Category I FPI is permitted to hold an ODI, subject to satisfaction of relevant conditions as well as

KYC norms.

Certain amendments have also been introduced in the FDI regime in the form of the Foreign Exchange

Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”) superseding the erstwhile Foreign Exchange

Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2017 (“TISPRO Regulations”) and Foreign Exchange Management (Acquisition and Transfer of Immovable Property in India)

Regulations, 2018. Further, the Reserve Bank of India (“RBI”) also notified the Foreign Exchange Management

(Debt Instrument) Regulations, 2019 (“DI Regulations”) superseding TISPRO and Foreign Exchange Management

(Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019 providing for reporting

requirements in relation to any investment under NDI Rules. While the law around foreign investment has not

been substantially modified by way of these amendments, there have been a few changes in nomenclature of

instruments, power of the RBI and some seemingly unintended changes due to omission of certain provisions

from the TISPRO. The NDI Rules also clearly demarcate between ‘debt instruments’ and ‘non-debt instruments’,

which includes ‘capital instruments’ under the TISPRO and also certain other kinds of instruments in AIFs, Real

Estate Investment Trust (“REITs”), Infrastructure Investment Trust (“InvITs”), etc.



Further, certain sectoral caps and related changes were brought in through Press Note. 4 in 2019, which have been

incorporated into the NDI Rules. Pertinently, (a) the sectoral cap for single brand retail trading has been increased to

100% from 49%; (b) it has been clarified that ‘manufacturing activities’ includes contract manufacturing; (c) 26% FDI

has been permitted in ‘Uploading/ streaming of news and current affairs through digital media’ under the Government

route; and (d) it has been clarified that e-commerce activities can only be undertaken by an Indian entity.

To be or not to be - Mauritius continues to be attractive

Early in 2020, there were some concerns in respect of Mauritius as a route for investing in India, especially

from the FPI perspective, since Mauritius was included in the Financial Action Task Force (FATF) ‘Grey List’.

Nonetheless SEBI put these concerns at bay by coming out with clarifications to the effect that Mauritius vehicles

continue to be eligible for FPI registration, subject to increased monitoring as per FATF norms. Mauritius has also

gone a long way in ramping up and tightening its laws, providing comfort to the investors, who are still drawn to

Mauritius due to low costs and other reasons.

The market seems to have made peace with the withdrawal of capital gains exemptions as per the protocol signed

between India and Mauritius in 2016 to amend the India-Mauritius Double Taxation Avoidance Agreement (the

“Protocol”), which now gives India a source-based right to taxation of capital gains arising out of sale of shares.

The Protocol is in fact seen as a welcome change as it brought certainty and added benefits in respect of interest

income. Mauritius will now emerge as the preferred jurisdiction for debt investments into India, in light of such

benefits. Having said this, there are still instances wherein tax authorities continue to question the benefits under

the India-Mauritius Double Taxation Avoidance Agreement (“India-Mauritius DTAA”) on account of lack of

commercial substance. However, Mauritius remains an attractive destination for India investments owing to non-

tax reasons as well.

Singapore - Reinvents itself with the VCC regime

Singapore remains attractive for larger funds which can afford substantial set-up and management costs, compared

to other jurisdictions such as Mauritius. Singapore’s new Variable Capital Company (VCC) regime has become quite

popular; however its efficacy from the perspective of investing into Category I & II AIFs remains somewhat low.)

Designing a fund: more of an Art than a Science

Designing a fund is not just an exercise in structuring. It’s like being an architect is different from being a

structural engineer. In case of India-focused funds, over and above knowledge of the Indian regulatory and tax

framework, a deep insight into cross-border legal and tax regimes is essential, regardless of whether funds are

being raised overseas.

The investment fund industry clearly seems to be in a very different market today. In mid-2016, Indian funds

started seeing greater participation from domestic LPs (as compared to so far being primarily led by overseas

investors). Innovative structures varied from the traditional ‘blind-pool model’ are increasingly being seen. One

of the major themes that has been continuing, especially from 2017, is the shift from ‘co-investment structures’ to

‘unified structures’, especially in funds with both domestic and foreign LP participation given the relaxation of FDI

norms for investment in AIFs and tax certainty brought about by recent changes to the double taxation avoidance

agreements of India with different countries. India, as an investment destination, has also gained popularity among

hedge funds. Innovative structures such as hedge funds with private equity side pockets are also being adopted.

Other innovative structures are also coming up, with variations in the traditional unified structure, including a

combination of a unified and a co-investment structure to cater to commercial expectations while complying




with legal, regulatory and tax requirements. Changes in legal regimes are also altering sectoral focus – for example,

the implementation of a newly introduced statute on insolvency and bankruptcy has led to substantial interest in

creating investment platforms for accessing stressed assets. Following closely on the footsteps of the observations

by U.S. Securities and Exchange Commission (“SEC”) that there are several disconnects between “what [general

partners] think their [limited partners] know and what LPs actually know”, SEBI mandates certain disclosure and

reporting norms that AIFs have to observe.

However, from a regulatory viewpoint, the glare from the regulator to the alternative investments space has

been at its peak. A manager to an AIF must now contend with greater supervision and accountability to both

the regulator and the investors. While bespoke terms are designed to maintain investor friendliness, given the

recent observations by regulators in sophisticated jurisdictions, sight must not be lost on the disclosure norms

and fiduciary driven rules that are now statutorily mandated. There is increasing guidance from SEBI, including

on aspects such matters relating to treasury functions (permitted temporary investments) and investment

restrictions under the regulations.

US regulatory changes

In the United States, the primary laws regulating investment funds are the Securities Act of 1933, the Securities

Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisers Act of 1940. Following

the financial crisis of 2008, a number of legislations have been introduced. These include the Dodd- Frank Act,

the Foreign Account Tax Compliance Act (“FATCA”) and the Jumpstart Our Business Startups Act (“JOBS Act”).

These legislations were enacted with the twin purpose of preventing future financial crisis on one hand and

facilitating the process of economic recovery on the other. From an investment fund perspective, these statutes

assume importance in the context of investor limitations and disclosure requirements that they usher into

the regulatory regime. Further, the US Internal Revenue Service has recently released proposed regulations on

taxation of carried interest under the Internal Revenue Code of 1986.

Attracting European investors

The European Commission introduced the Alternative Investment Fund Managers Directive (“AIFMD”) with

a view to provide a harmonized and stringent regulatory and supervisory framework for the activities of fund

managers within the European Union. The AIFMD seeks to regulate non-EU fund managers who seek to market

a fund, set up outside the EU to investors in the EU.

Other changes and the GIFT City in India

Back home, in 2015, SEBI had constituted a standing committee called the Alternative Investment Policy Advisory

Committee (“AIPAC”) under the chairmanship of Mr. Narayana Murthy to advise SEBI on measures to further

develop the alternative investment and startup ecosystem in India and to highlight any hurdles that might

hinder the industry’s development. The first AIPAC report of January, 2016 recommended various structural

reforms. Some of the recommendations were adopted in the 2016 annual budget that was tabled by the Finance

Minister. The second AIPAC report of December, 2016 recommended changes which pertained to more detailed

disclosures in offering documents by the GPs, better reporting norms, unlocking the domestic pool of capital

(pension funds and insurance companies), performance statistics and benchmarks to be standardized for the

industry. The third AIPAC report which was released on January 19, 2018 further proposed reforms in the Goods

& Services Tax (“GST”) regime as applicable to the growth of AIFs in India and promoting AIFs in India through

the International Financial Services Centers (“IFSCs”). It also continues to advocate changes in the tax regime

for Category III AIFs and recommendations made previously in AIPAC reports on application of corporate social



responsibility (“CSR”) funds for impact investing. The fourth AIPAC Report released on July 23, 2018 emphasized

the need of onshoring of foreign pools and expanding domestic capital pools, suggested exemption of GST on

fund management and other services on AIFs receiving foreign capital and also reiterated the development of a

powerful ecosystem spanning angel investors and angel funds, venture funds, social impact funds and AIFs, to

catalyse the start-up revolution in India. The AIPAC reports mark a welcome start for necessary dialogue that is

required between the industry and the regulator; however, all the recommendations have not yet been translated

into changes yet.

SEBI has also introduced an online system for filings related to AIF. This online system can be used for application

for registration, reporting and filing in terms of the provisions of AIF Regulations and circulars issued thereunder.

Although there were certain teething issues faced in the transition to the online system, it is encouraging that

SEBI, in line with the government’s initiative to promote the alternative investment asset industry in India, is

consistently making efforts towards ease of regulatory formalities to operate in the industry.

Separately, there is also emerging jurisprudence which suggests that the threshold of fiduciary duties to be met

with by fund managers is shifting from “exercising supervision” to “making reasonable and proportionate efforts

commensurate with the situations”. A failure to perform such supervisory role could raise severe issues on fund

managers’ liabilities for business losses as would be seen in the case of fund directors in Weavering Macro Fixed

Income Fund, which continues to hold the most value in terms of precedence in fund governance jurisprudence.

To add to this, there has been a very active enforcement of anticorruption laws under the Foreign Corrupt

Practices Act (“FCPA”) against directors and executives.

Accordingly, apart from the expectation to set up investor-friendly structures, the shift in legal paradigm in which

an investment fund operates, requires that attention be given to articulating disclosures in fund documents

(including recording the economic substance and justifications in the fund’s board minutes) and intelligently

planning investment asset-holdings.

Globally, funds have been accorded pass through status to ensure fiscal neutrality and investors are taxed based

on their status. This is especially relevant when certain streams of income may be tax free at investor level due

to the status of the investor, but taxable at fund level. India has also accorded a pass-through status to Category I

and Category II AIFs registered with SEBI with a requirement to subject any income credited or paid by the AIFs

to a withholding tax of 10% for resident investors and as per the “rates in force” for non-resident investors. Pass

through status has still not been accorded to Category III AIFs. The tax uncertainty places Category III AIFs at a

significant disadvantage against off-shore funds with similar strategies. However, recently, certain tax incentives

and clarifications have been provided to Category III AIFs established in IFSC to bring them at par with FPIs.

While bespoke managed accounts are being created and structures that meet LPs’ demand to be more ‘closely

aligned to the portfolio selection process’ are being set up, it is imperative to design funds which address the issues

created by the continuously changing Indian and international regulatory and tax environment.

Increased tax complexities

The introduction of the General Anti-Avoidance Rules (“GAAR”) in Indian domestic law has brought in a shift

toward a ‘substance over form’ approach in India, an approach that is also reflected in other actions of the Indian

government – in actively participating in the Organisation for Economic Co-operation and Development’s

(“OECD”) Base Erosion and Profit Shifting (“BEPS”) project, recent policy changes, etc. Further, as a result of

Action Plan 15 of the BEPS project, the Multilateral Instrument (“MLI”) was brought into force on July 1, 2018 and

it entered into force for India on October 1, 2019. The MLI seeks to introduce a limitation of benefit (“LoB”) rule

(detailed or simplified) or the principal purpose test (“PPT”) to covered tax agreements (“CTAs”). Since few states




have chosen the LoB rule, it is anticipated that the PPT will be incorporated in more than 1100 treaties. Having

said this, it will be important to examine the interplay of the provisions of GAAR and the PPT rule under the tax

treaties and determine its impact on fund structuring.

Further, in 2020, one of the biggest announcements from the Ministry of Finance while delivering the Union

Budget 2020-21 (“Budget”) was the removal of Dividend Distribution Tax (“DDT”) which was an additional

tax paid at the company’s level. Instead, shareholders will now have to discharge taxes on dividends received.

This is a welcome move and comes as a huge relief to the foreign investor community who are often faced with

the difficulty of not being able to claim tax credit in the country of residence or take benefit of withholding tax

rates under the applicable tax treaty. Similarly, attempts have been made to boost the infrastructure sector by

expanding the scope of pass through taxation to private unlisted InvITs. This was a long-standing demand of the

investor community especially considering that the SEBI regulations have done away with the mandatory listing

requirement of InvITs. While the Finance Act, 2017, exempted Category I FPIs and Category II FPIs registered

under the FPI Regulations 2014 from indirect transfer tax provisions in India, considering the consolidation of

categories of FPIs under the FPI Regulations 2019, the Budget has exempted the applicability of indirect transfer

tax provisions to Category I FPIs under the FPI Regulations 2019.

Tax incentives to Sovereign Wealth Funds and Pension Funds

Another big reform that the Budget introduced are tax exemptions to sovereign wealth funds. The Budget has

exempted income in the nature of dividend, interest or long-term capital gains earned by sovereign wealth funds

through investments in the infrastructure space who fulfil certain specified criteria. Notably, the Abu Dhabi

Investment Authority (“ADIA”) and its subsidiaries have been specifically exempted. Although, under some

tax treaties, sovereign wealth funds are exempted, specific provisions under the Income-tax Act, 1961 (“ITA”)

will provide more certainty and clarity in this respect. The intent behind this move is to encourage long term

stable capital participation from sovereign wealth funds, to replace government spending in the creation of

infrastructure assets and also foster economic relations with such countries.

Conclusions

The shift in the legal paradigm in which an investment fund operates requires that attention be given to

articulating disclosures in fund documents (including recording the economic substance) and intelligently

planning investment asset-holdings. In our experience, fund documentation is critical in ensuring protection

for GPs from exposure to legal, tax and regulatory risks. Fund counsels are now required to devise innovative

structures and advise investors on terms for meeting LP expectations on commercials, governance and

maintaining GP discipline on the articulated investment strategy of the fund. All these are to be done in

conformity with the changing legal framework.

The objective of this compilation is to bring to focus, aspects that need to be considered while setting up India-

focused funds and some of the recent developments that impact the fund management industry.

Regards,

Nishith Desai



NDA Fund Formation Practice

Our Approach

At Nishith Desai Associates, we are particularly known and engaged by multinational companies and funds

as strategic counsels. As engineers of some of the earliest innovative instruments being used by investment

funds (both private equity and venture capital) in India we proactively spend time in developing an advanced

understanding of the industry as well as the current legal, regulatory and tax regime.

Diagnostics and Structuring

Structure follows strategy, and not vice versa. Developing an appropriate strategy is crucial in determining

not just the structure, but also the architecture of the fund platform. Adopting strategies for tapping different

categories of global investors, including institutional investors and non-institutional investors (such as family

offices and ultra-high net worth individuals) and on conformity with global benchmarks, such as the Institutional

Limited Partners’ Association (ILPA) Principles 3.0, the European Union’s AIFMD have been gaining prominence

in the recent times. Strategic framework also needs to be developed for incorporation of best practices on rights

and liabilities of different counterparties, LP negotiations and drafting of various fund terms including key person

provisions, currency exchange related issues and removal provisions.

Selection of the fund vehicle requires careful planning and is driven by a variety of considerations as the same

would have an impact on the investors in the fund; particularly in their home jurisdictions. While deciding on the

optimum structure for a fund, varied objectives such as limited liability for investors, commercial convenience

and tax efficiency for investors and managers need to be considered. To meet these objectives, varied entities such

as pass-through trusts, limited liability partnerships, limited partnerships, limited liability companies, protected

cell companies etc. can be considered. Offshore funds investing in India may require the presence of investment

advisors in India to provide them with deal recommendations etc. This gives rise to tricky issues relating to

the taxation of such offshore funds in India that would depend on whether the Indian advisor is regarded as a

‘permanent establishment’ of the offshore fund in India or may lead to a risk of ‘place of effective management’

(“POEM”) of the offshore fund held to be in India. In this regard, we have successfully represented several funds

before the Indian Authority for Advance Rulings and have obtained landmark rulings for them.

After the OECD issued its report on Action Plan on BEPS, there has been an increased pressure to ensure

observance of key tax principles like demonstrating substance, establishing tax resident status and transfer pricing

principles. Tax authorities in several mature financial centers are adopting substance over form approach.

The implementation of the GAAR allows Indian tax authorities to re-characterize transactions on grounds of lack

of commercial substance among other things. This has prompted a shift while structuring funds to concentrate

several aspects constituting ‘commercial substance’ in the same entity. So, unless specific investors require ‘feeder’

vehicles for tax or regulatory reasons, an attempt is being made to pool LPs in the same vehicle that invests in the

foreign portfolio. Mauritius, Netherlands, Singapore and Luxembourg continue being favorably considered while

structuring India funds or funds with India allocation.

To accommodate both domestic investor base and offshore investor base, unified structures have emerged as a

preferred choice for structuring India focused funds. There is also an increased participation from DFIs in India

focused funds, including unified structures. Accordingly, some global benchmarks need to be followed when




designing the structure and calibrating the fund documents including the governance, fiduciary aspects and

adherence to Environment and Social (“ESG”) policies.

After the introduction of tax pass through for Category I and Category II AIFs, GPs have now started

contemplating the structuring of Category I and Category II AIFs as limited liability partnerships (“LLPs”).

However, trusts continue to be the choice of vehicle for AIFs in India as compared to LLPs on grounds of stricter

regulatory formalities and compliances in case of an LLP, lack of flexibility to determine the Fund’s own rules of

governance (which are not the same as rules of corporate governance) in case of an LLP and the risk of mixing up

of investment assets and liabilities of the AIF with the management assets and liabilities of the AIF manager (if

the employees of the manager and / or the manager entity itself are expected to participate in the AIF LLP as well).

LLPs in India, as currently governed by the Limited Liability Partnership Act, 2008, (“LLP Act”) do not have the

regulatory flexibility to implement fund governance norms alongside corporate governance norms.

Documentation

Once a decision has been taken on the optimum structure for the fund, the same has to be carefully incorporated

in the fund documents including the charter documents for the fund entity, the private placement memorandum,

the shareholders’ agreement, the share subscription or contribution agreement, the investment management

agreement, the investment advisory agreement, etc. In particular, one would need to keep in mind the potential

“permanent establishment” risk while drafting these documents. Recently, SEBI issued a circular mandating AIFs

to adhere to a template private placement memorandum ensuring that a minimum standard of disclosure is

made available in the private placement memorandum. Further, in order to ensure compliance with the terms

of the private placement memorandum, it has been made mandatory for the AIF to carry out an annual audit

of such compliance. However, the circular also talks about waiver to abide by the template private placement

memorandum and the audit requirements in certain specific circumstances as provided in the relevant circular.

The private placement memorandum should also achieve a balance between the risk disclosure requirements and

the marketing strategy. We also co-ordinate with overseas counsel to obtain requisite legends to keep the fundraising

exercise compliant with the laws of each jurisdiction in which the interests of the fund are being marketed.

Advisory

In addition to preparing the necessary fund documents, we also advise the fund on the local registration

requirements. Domestic funds may register themselves with SEBI pursuant to which they are required to comply

with certain investment restrictions and other prescribed conditions. Domestic funds are also accorded pass-

through status for Indian tax purposes upon the fulfilment of certain conditions. It is not mandatory for offshore

funds to register with SEBI. However, there are certain benefits available to offshore funds that register with SEBI

as ‘foreign venture capital investors’ (“FVCI”) such as flexibility in entry and exit pricing, “Qualified Institutional

Buyer” status, etc. Further, with respect to funds seeking to participate in the secondary markets, apart from

drafting of the information memorandum which is circulated to the investors of such fund, we have also advised

and assisted them in obtaining registration as FPIs. We also advise funds on a day to day basis from an Indian tax

and regulatory perspective in relation to the execution of ODIs including P-notes.



LP Negotiations

LPs (particularly the first close LPs and institutional investors) to India focused funds have increasingly started

negotiating fund terms with the GPs with rigorous review of the fund documentation. Further, there is often

a need to harmonize the fund documents to cater to the requirements of foreign institutional investors / DFIs,

which may vary or differ from those of Indian financial institutions.

Funds with a mixed pool of investors (domestic and foreign, institutional and retail) often face various issues

on fund terms including with respect to allocation of placement agent expenses, set-up costs for a feeder vehicle

to cater to foreign investors, exposure of the corpus of the fund to exchange rate fluctuations. Therefore, it

not only becomes critical for GPs to ensure that they are able to accommodate the LP asks within the realms

of the structure in the most efficient manner but also for the legal advisors to ensure that they are adequately

incorporated in the fund documentation.

Sponsor and Carry Structuring

With an increasing industry demand for a skin-in-the-game, GPs of India focused funds have also begun exploring

different innovative structures for employee GP commitment and carry structuring. Carry structuring involves a

careful analysis of both regulatory and tax laws applicability on certain aspects, while looking at the jurisdiction

of residence and taxation of the ultimate carry recipients and also the proportionality of investment in the fund

vehicle by such recipients as employee GP commitment.

Global Project Management

Several Indian investment managers who are looking at raising funds with international investors need to

offer tax efficient and regulatory compliant structures to the foreign investors that generally seek safety and

repatriation of their original investments along with a tax-efficient way of receiving the gains earned. Thus, our

focus on international tax and our in-depth understanding of the legal, regulatory and tax regimes for funds in

different jurisdictions has enabled us to be at the cutting edge of structuring offshore and domestic funds.




Primary Contacts

Nishith Desai [email protected]

Nishith Desai is the founder of the research-based strategy driven international law firm, Nishith Desai Associates

(www.nishithdesai.com) with offices in Mumbai, Silicon Valley, Bangalore, Singapore, Mumbai – BKC, New

Delhi, Munich and New York.

Nishith himself is a renowned international tax, corporate, IP lawyer researcher, published author and lecturer

in leading academic institutions around the world. He specializes in Financial Services sector and assisted

Government of Mauritius and Government of India in establishment of their offshore financial centers.

Soon after India opened up its economy to the outside world in 1991, he established the first five India Focused

funds and pioneered the roots of asset management industry and the firm has now worked for over 900 funds

across all classes of asset. As a pioneer in the Indian investment funds industry, Nishith is known for developing

new models in fund formation such as the first India focused index fund, first private equity fund, first VC fund

and real estate fund and was also a member of SEBI’s committee which developed original regulations for Foreign

Venture Capital Investor (FVCI) and Venture Capital Funds regime. More recently, he has been involved with the

formation and subsequent amendments to the AIF Regulations.

http://[email protected]



Pratibha [email protected]

Pratibha Jain is the Founding Partner and also the Head of the Delhi office of Nishith Desai Associates. She heads

the Banking and Finance and Regulatory practice at NDA. Ms. Jain brings with her a breadth of international and

Indian experience having worked in New York, Tokyo, Hong Kong and Mumbai.

Ms. Jain’s educational qualifications include B.A (Economics) Hons. and LL.B. degree from Delhi University, a

Bachelor of Civil Law degree from the University of Oxford, and a LL.M. degree from the Harvard Law School.

Her areas of focus include FDI investments, banking and finance and corporate and regulatory advisory. Her client

list includes marquee corporate and private equity clients including, Softbank, Amazon, Flipkart, Morgan Stanley,

JP Morgan Chase, Deutsche Bank, Deutsche Boerse, Tiger Global, Soros, Norwest Venture Partners, General

Atlantic, SAIF Partners, Everstone Capital, Bombay Stock Exchange and Ministry of Finance. She sits on various

important committees including FICCI Capital Markets Committee and FICCI Sub-committee on Internet and

Social Media.

She has worked on some of the most challenging projects in financial services and regulatory sector, including

representing Ministry of Finance for structuring of India’s first sovereign wealth fund with proposed corpus

of over six billion dollars and advising Ministry of Commerce on their policy on Bilateral Investment Treaties,

representing FDI investors in multiple acquisitions and entry strategies into India, representing investors for

facilitating listing of stock exchanges in India, representing underwriter’s for listing of Bombay Stock Exchange,

representing investors in investigations by the Enforcement Directorate and representing FSSAI on creating

regulations for audits.




Parul [email protected]

Parul is Co-head, International tax and Fund Formation Practices at Nishith Desai Associates with over 20

years of experience. She is a Chartered Accountant, a Certified Public Accountant and an advocate, she focuses

primarily on international taxation and Fund Formation practice areas including cross border investments and

venture capital / private equity funding structures. She has advised various private equity clients with respect

to their portfolio business operations restructuring, including advice on M&A transactions, spin offs and group

reorganisation strategies. She was previously a partner in the Financial Services and M&A Tax Practices at a Big

Four accounting firm.

Parul has been recognised by International Tax Review World Tax 2013 guide. She has also been listed in The

Legal500 Directory and has been recognized as one of the Leading Women Leaders in Tax 2016 and in 2017 by

International Tax Review. She was also part of a special Committee set up by Securities and Exchange Board of

India to evaluate the Angel Fund Regulations.



Nishchal [email protected]

Nishchal Joshipura is a Partner and co-heads the Fund Formation practice at Nishith Desai Associates. He is

a Chartered Accountant, an MBA and a Lawyer. He is also a Partner in the Mergers & Acquisition and Private

Equity practice. Nishchal specializes in legal and tax structuring of cross-border transactions and assists clients

on documentation and negotiation of mergers and acquisition (M&A) deals. His other practice areas include

Corporate & Securities laws, Transfer Pricing, International Taxation, Globalization, Structuring of Inbound /

Outbound Investments, Private Equity Investments, Structuring of Offshore Funds, Taxation of E-Commerce and

Exchange Controls. He has contributed several articles in leading publications like Asialaw and has been a speaker

at many domestic and international conferences.

He has been highly “Highly Recommended” by various legal directories for legal and tax advice on M&A, Private

Equity and Investment Funds. He has been nominated as a “Young Achiever” at the Legal Era Awards 2015 based

on industry research, reviews, rating and surveys conducted by Legal Era.




Kishore [email protected]

Kishore Joshi heads the Regulatory Practice at Nishith Desai Associates. He has over two decades of experience in

advising clients on securities and exchange control laws. He handles matters on various aspects related to foreign

portfolio investors including the broad-based criteria, eligibility to trade P-Notes and the participation of various

investor categories under the FPI route.

Kishore has interacted extensively with the securities and exchange control regulator and has made numerous

representations seeking reform in the law. In addition, he regularly advises clients on fund investments,

issues related to corporate and regulatory laws. He has made several presentations on inbound and outbound

investments. Kishore holds a Bachelor’s degree in law from Mumbai University and is a member of the Bar

Council of Maharashtra & Goa.



Nandini [email protected]

Nandini Pathak is a Leader in the Investment Funds practice at Nishith Desai Associates and is actively involved in

the firm’s thought leadership on the venture capital and private equity side. With a strong focus on VC / PE funds,

she has advised several international and domestic clients on legal, regulatory and tax issues, fund governance

and fund economics best practices and negotiations with various participants at the fund formation stage. She

frequently interacts with the securities regulator and custodians. Her expertise includes tax efficient structuring

for India focused funds as well as investor negotiations.

With her practice base on the fund formation side, she also regularly advises clients on the regulatory front

including securities laws and exchange control laws. She believes in thought leadership through knowledge

sharing, and frequently authors publicly available analysis on relevant topics in the investment funds industry.

Nandini holds a B.A.LL.B. (hons). degree from Jindal Global Law School, and has recently (in 2019) been recognized

as a ‘Distinguished Alumni Award for Exemplary Accomplishments in Professional Service / Work’ by her alma

mater. She is also currently completing her LL.M. (Corporate and Finance Law) from Jindal Global Law School, her

alma mater.




Contents

1. GLOSSARY OF TERMS 01

2. CHOICE OF JURISDICTION FOR SETTING UP AN INDIA-FOCUSED FUND 04

I. Why Offshore Investors are Pooled Outside India 04II. Why Onshore Investors are Pooled in India 04III. Which Jurisdictions are Typically Considered for Setting up India

Focused Funds Pooling Offshore Investors 05

3. STRUCTURAL ALTERNATIVES FOR INDIA-FOCUSED FUNDS 09

I. Structuring India focused Offshore Funds 09II. Foreign Investment Regimes 09III. Certain Tax Risks 14

4. ALTERNATIVE INVESTMENT FUNDS IN INDIA 17

I. Introduction 17II. Alternative Investment Funds 17III. Choice of Pooling Vehicle 17IV. Classification of AIFs 19V. Investment Conditions and Restrictions under the AIF Regulations 20VI. Key Themes under the AIF Regulations 22VII. Taxation of Alternative Investment Funds 26

5. TRENDS IN PRIVATE EQUITY 30

I. Trending fund terms 30

6. FUND DOCUMENTATION 34

I. At The Offshore Fund Level 34II. At The Onshore Fund Level 35III. Investor Side Letters 36IV. Agreements with Service Providers 36V. Applicability of Stamp Duty 37

7. HEDGE FUNDS 38

I. FPI Regulations 38II. Participatory Notes and Derivative Instruments 42III. Onshore Hedge Funds 43

8. FUND GOVERNANCE 45

I. Investment Manager 45II. Investment Committee 45III. Advisory Board 45IV. Aspects and Fiduciaries to be considered by Fund Directors 45




9. INTERNATIONAL TAX CONSIDERATIONS 49

I. Taxation of Indirect Transfers 49II. General Anti-Avoidance Rule (GAAR) 51III. Business Connection/ Permanent Establishment Exposure 52

ANNEXURE I 56

Sector Focused Funds 56

ANNEXURE II 60

Summary of Tax Treatment for Mauritius and Singapore Based Entities Participating in Indian Opportunities 60




1

1. Glossary of Terms

Term Explanation

AAR Authority for Advance Ruling, Ministry of Finance, Government of India

AC Authorised Company

ADIA Abu Dhabi Investment Authority

AIF Alternative Investment Fund as defined under the SEBI (Alternative Investment Funds) Regulations, 2012

AIFMD Alternative Investment Fund Managers Directive

AIF Regulations SEBI (Alternative Investment Funds) Regulations, 2012

AIPAC Alternative Investment Policy Advisory Committee

AML Anti-Money Laundering

AUM Assets under management

AOP Association of Persons

BACO Best Alternative Charitable Option

BEPS Base Erosion and Profit Shifting

BIPA Bilateral Investment Promotion and Protection Agreements

BIS Bank for International Settlements

CBDT Central Bureau of Direct Taxes, Department of Revenue, Ministry of Finance, Government of India

CBLO Collateralized Borrowing and Lending Obligations

CCD Compulsorily Convertible Debentures

CCPS Compulsorily Convertible Preference Share

Companies Act The Companies Act, 1956 and/or the Companies Act, 2013 (to the extent as may be applicable)

COR Certificate of Registration

CSR Corporate Social Responsibility

CTA Covered Tax Agreements

DDP Designated Depository Participant

DDT Dividend Distribution Tax

DFIs Development Financial Institutions

DI Regulations Foreign Exchange Management (Debt Instruments) Regulations, 2019

DTAA Double Taxation Avoidance Agreement

ECB External Commercial Borrowing

EEIG European economic interest groupings

ESG Environment, Social and Governance policies

FATCA Foreign Account Tax Compliance Act

FATF Financial Action Task Force

FATF Release Jurisdictions under Increased Monitoring

FCCB Foreign Currency Convertible Bond

FCPA Foreign Corrupt Practices Act

FDI/ FDI Policy Foreign Direct Investment / Consolidated Foreign Direct Investment Circular of 2017

FEMA Foreign Exchange Management Act, 1999

FII Foreign Institutional Investor

FII Regulations SEBI (Foreign Institutional Investors) Regulations, 1995

FIPB Foreign Investment Promotion Board, Department of Economic Affairs, Ministry of Finance, Government of India

FPI Foreign Portfolio Investor

FPI Regulations 2019 SEBI (Foreign Portfolio Investors) Regulations, 2019



2

FSC Financial Services Commission, Mauritius

FVCI Foreign Venture Capital Investor

FVCI Regulations SEBI (Foreign Venture Capital Investors) Regulations, 2000

FTS Fees for Technical Services

GAAR General Anti-Avoidance Rules

GBC-1 Category 1 Global Business (GBC–1) License

GIIN Global Impact Investing Network

GIIRs Global Impact Investing Rating System

GPs General Partners (Fund Managers)

GST Goods & Services Tax

GoI Government of India

JOBS Act Jumpstart Our Business Startups Act

IC Investment Committee

ICDR Regulations SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009

IFSC International Financial Services Centers

Indian Rupee or “INR” or “Rs.” The currency of Republic of India

InvIT Infrastructure Investment Trust registered with SEBI under the SEBI (Infrastructure Investment Trusts) Regulations, 2014

IOSCO International Organization of Securities Commissions

IP Intellectual Property

IPO Initial Public Offer

IRIS Impact Reporting & Investment Standards

ITA Income-tax Act, 1961

KYC Know Your Customer

LoB Limitations on Benefits

LLP Limited Liability Partnership

LLP Act Limited Liability Partnership Act, 2008

LPAC Limited Partners’ Advisory Committee

LPs Limited Partners (Fund Investors)

LRS Liberalised Remittance Scheme

MAT Minimum Alternate Tax

MIM Multiple Investment Management

Minimum Investment Amount INR 10 million

MLI Multilateral Instrument

NAV Net Asset Value

NCD Non-convertible Debentures

NDI Rules Foreign Exchange Management (Non-debt Instruments) Rules, 2019

NRI Non-Resident Indian

OCB Overseas Corporate Body

ODI Offshore Derivative Instrument

ODI Regulations Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2004

OECD Organisation for Economic Co-operation and Development

Onshore Fund Domestic Pooling Vehicle

Operational Guidelines Operational Guidelines for FPIs, DDPs and EFIs

OEIC Open-ended Investment Company

ODI Offshore Derivative Instrument

Offshore Fund Means a pooling vehicle established outside India

P-notes Participatory notes

PAN Permanent Account Number




3

PCC Protected Cell Companies

PE Private Equity

PPM Private Placement Memorandum

P-Notes Participatory Notes

POEM Place of Effective Management

PPT Principal Purpose Test

Protocol Protocol signed between India and Mauritius to amend the Mauritius India Double Taxation Avoidance Agreement

QFI Qualified Foreign Investor

RBI Reserve Bank of India

REITs Real Estate Investment Trusts

RE Funds Real Estate Funds

RoC Registrar of Companies

RTA Registrar to an issue / share transfer agent

SCRA Securities Contracts (Regulation) Act, 1956

SEBI Securities and Exchange Board of India

SEC U.S. Securities and Exchange Commission

SGD Singapore Dollars

SITA Singapore Income Tax Act

SMEs Small and Medium-sized Enterprises

SPCs Segregated Portfolio Companies

SPV Special Purpose Vehicle

TDS Tax Deducted at Source

TRC Tax Residency Certificate

TISPRO Regulations Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017

USD US Dollars

VC Venture Capital

VCF Venture Capital Fund

VCF Regulations SEBI (Venture Capital Funds) Regulations, 1996

VCPE Venture Capital and Private Equity

VCU Venture Capital Undertaking

2015 Circular Circular no. 4 of 2015



4

2. Choice of Jurisdiction for Setting up an India-Focused Fund

There are several factors that inform the choice of

jurisdiction for setting up a pooled investment vehicle.

A suitable jurisdiction for setting up a fund should

primarily allow tax neutrality to the investors.

‘Neutrality’ ensures investors are not subject to any

higher taxes than if they were to invest directly. From

a regulatory viewpoint, the jurisdiction should allow

flexibility in raising commitments from resident as

well as non- resident investors, making investments

and distribution of profits.

The government is working towards easing the norms

for effective mobilization of the domestic pool of

investors in India (consisting of institutional investors

like banks, insurance companies, mutual funds and

high net worth individuals). The AIPAC reports1 have

also recommended unlocking domestic capital pools

for providing fund managers an access to domestic

pools as this investor class currently constitutes

approximately 10% of the total VCPE invested in

India annually. In fact, the fourth AIPAC Report has

also listed ‘expanding the existing domestic capital

pools’ as one of three imperative pillars for scaling up

the industry to its next phase of growth.2

I. Why Offshore Investors are Pooled Outside India

India follows source based taxation on capital gains

and taxes thereon may not be creditable in the home

jurisdiction of the offshore investors. Accordingly,

offshore structures are used for offshore investors

to invest into India to avoid double taxation on the

same income stream. Further, if the offshore investors

are pooled outside India, the requirement to obtain a

1. The report was issued on December 01, 2016 and can be accessed at http://www.sebi.gov.in/cms/sebi_data/ attachdocs/1480591844782.pdf. Our memo on AIPAC I (dated January 20, 2016) can also be accessed at http://www.nishithdesai. com/ information/research-and-articles/nda-hotline/nda-hotlinesingle-view/newsid/3304/html/1. html?no_cache=1).

2. https://ivca.in/wp-content/uploads/2018/08/AIPAC-4.pdf.

Permanent Account Number (“PAN”) card and filing

of tax returns will only be on the Offshore Fund, as

opposed to each of the offshore investors (in case of

direct participation of such investors in an onshore

pooling vehicle). Further, India does not have Bilateral

Investment Promotion and Protection Agreements

(“BIPA”) with all countries. Offshore investors are

accordingly pooled in jurisdictions which have a BIPA

with India, which may provide investors an access to

several reliefs, including fair and equitable treatment,

protection against expropriation, repatriability of

capital, an efficient dispute resolution framework

and other rights and reliefs. Further, India based

structures with foreign participation which are

not Indian managed and sponsored may require

regulatory approvals, compliance with pricing norms

and may be subject to performance conditions in

certain sectors.3

II. Why Onshore Investors are Pooled in India

Resident investors prefer onshore structures for the

following reasons:

a. The Liberalised Remittance Scheme (“LRS”)

issued by the RBI allows Indian resident

individuals to remit abroad up to USD 250,000

per person per financial year for any permissible

current or capital account transaction or a

combination of both, subject to the restrictions

and conditions laid down in the Foreign

Exchange Management Act, 1999 (“FEMA”)

and related rules and regulations.

3. Any downstream investment by an AIF (which receives foreign contributions) will be regarded as foreign investment if the Sponsor and the Investment Manager of the AIF are not Indian

‘owned and controlled’. The ownership and control is determined in accordance with the extant FDI Policy.

https://ivca.in/wp-content/uploads/2018/08/AIPAC-4.pdf.




5

b. Regulation 7 of the Foreign Exchange

Management (Transfer or Issue of any

Foreign Security) Regulations, 2004 (“ODI Regulations”) stipulates certain conditions to

be met by Indian corporations when making

investments in an entity outside India engaged

in financial services activities (including fund

or fund management vehicles). The conditions

include, inter-alia, that the Indian entity should

have earned net profits during the preceding

three financial years from the financial services

activities; that it is registered with the regulatory

authority in India for conducting the financial

services activities; that it has obtained approval

from the concerned regulatory authorities, both

in India and abroad, for venturing into such

financial sector activity; and has fulfilled the

prudential norms relating to capital adequacy

as prescribed by the concerned regulatory

authority in India. However, as in the case of

individual residents, Indian corporates investing

abroad into a fund which in turn invests into

India could raise round tripping concerns.

c. Under a domestic fund structure, the fund

vehicle (typically a trust entity registered with

SEBI as an AIF) is not to be taxed on any income

that is earned from the investments. The

income earned is taxable in the hands of the

investors when the venture capital fund / AIF

distributes the same to the investors. Further,

the characterization of income in their hands

is the same as that realized / distributed by the

investee company to the fund.

By contrast, if distributions were to be received in

the form of dividend or interest from an Offshore

Fund structure, the Indian resident investors would

typically have to recognize the distribution as

‘income’ and as a result, could be taxed in India (at the

time of receipt).

III. Which Jurisdictions are Typically Considered for Setting up India Focused Funds Pooling Offshore Investors

A. Mauritius

Mauritius was the second largest source of FDI into

India in 2019-20, with USD 8.2 billion worth of

inflows coming in from Mauritius.4 Between 2000

and 2017, FDI from Mauritius accounted for 34% of

the total FDI received by India.5

On February 21, 2020, the FATF issued a list of

‘Jurisdictions under Increased Monitoring’ (“FATF Release”), commonly known as the ‘Grey List’,

which included Mauritius alongside 17 other

jurisdictions. These jurisdictions are actively working

in collaboration with the FATF to find solutions

and address strategic deficiencies in their regimes to

counter money laundering, terrorist financing, and

proliferation financing. While the FATF does not

call for the application of enhanced due diligence

to be applied to these jurisdictions, Mauritius’s

Minister of Financial Services & Good Governance

has announced that the island is introducing the

necessary measures. SEBI clarified however, in a

press release dated February 25 2020, that “FPIs from

Mauritius continue to be eligible for FPI Registration

with increased monitoring as per FATF norms”.

The Mauritius Financial Services Commission

(“FSC”) issued its first ‘Anti-Money Laundering and

Countering the Financing of Terrorism Handbook’,

designed to assist licensed financial institutions

to adopt a ‘more effective, risk-based and outcome-

focused approach’ in January, 2020. The Handbook

offers financial institutions guidance on applying

national measures to combat, inter-alia, money

laundering and terrorist financing.

4. https://dipp.gov.in/sites/default/files/FDI_Factsheet_December-19_5March2020.pdf.

5. https://dipp.gov.in/sites/default/files/FDI_FactSheet_January_March2017.pdf.

https://dipp.gov.in/sites/default/files/FDI_Factsheet_December-19_5March2020.pdf.

https://dipp.gov.in/sites/default/files/FDI_Factsheet_December-19_5March2020.pdf.

https://dipp.gov.in/sites/default/files/FDI_FactSheet_January_March2017.pdf.

https://dipp.gov.in/sites/default/files/FDI_FactSheet_January_March2017.pdf.



6

India and Mauritius have shared close economic,

political and cultural ties for more than a century.

There has been close cooperation between the

two countries on various issues including trade,

investment, education, security and defence.

The India-Mauritius DTAA underwent a change

through the Protocol signed between India and

Mauritius on May 10, 2016. Prior to the Protocol, the

India-Mauritius DTAA included a provision that

exempted a resident of Mauritius from Indian tax

on gains derived from the sale of shares of an Indian

company. The Protocol however, gave India a source

based right to tax capital gains which arise from

alienation of shares of an Indian resident company

acquired by a Mauritian tax resident (as opposed to

the previous residence based tax regime under the

India-Mauritius DTAA). However, the Protocol had

provided for grandfathering of investments and the

revised position became applicable to investments

made on or after April 01, 2017. In other words, all

existing investments up to March 31, 2017 had been

grandfathered and exits / shares transfers in respect

of such investments beyond this date would not be

subject to capital gains tax in India. Additionally, the

Protocol introduced a LoB provision which shall be a

pre-requisite for a reduced rate of tax6 (50% of domestic

tax rate) on capital gains arising during a two-year

transition period from April 01, 2017 to March 31, 2019.

The modification on capital gains taxation is limited to

gains arising on sale of shares. This ensures continuity

of benefit to other instruments and also provides much

needed certainty in respect of the position of the India-

Mauritius DTAA. However, despite this, transactions in

the context of the India-Mauritius DTAA continue to

be closely scrutinized by tax authorities in India.

Income from sale of debentures continues to enjoy

tax benefits under the India-Mauritius DTAA. That,

coupled with the lower withholding tax rate of 7.5%

for interest income earned by Mauritius investors

from India, comes as big boost to debt investments

from Mauritius. Prior to the Protocol, interest

income arising to Mauritius investors from Indian

securities / loans were taxable as per Indian domestic

6. This benefit shall only be available to such Mauritius resident who is (a) not a shell/conduit company and (b) satisfies the main purpose and bonafide business test.

law. The rates of interest could go as high as 40% for

rupee denominated loans to non-FPIs. The Protocol

amended the DTAA to provide for a uniform rate of

7.5% on all interest income earned by a Mauritian

resident from an Indian company. The withholding

tax rate offered under the India-Mauritius DTAA is

significantly lower than those under India’s treaties

with Singapore (15%) and Netherlands (10%). This

should make Mauritius a preferred choice for debt

investments into India, going forward.

Further, the Protocol introduced Article 26A to the

India-Mauritius DTAA. It provided that India and

Mauritius shall lend assistance to each other in the

collection of revenue claims. It allowed for Mauritius

authorities to enforce and collect taxes of Indian

revenue claims, as if such claims were its own, upon

a request from Indian revenue authorities. Currently,

Mauritius has not included India in the relevant

notifications and accordingly, the India-Mauritius

DTAA is not a CTA. In case Mauritius notifies India-

Mauritius DTAA as CTA, there could be a significant

change in tax consequences for investments made

through the Mauritius route.

On a separate note, the FSC had introduced domestic

substance rules to be satisfied by Mauritius based

GBC-1 entities after January 01, 2015.

The same were amended vide circulars issued by the

FSC on October 12 and 15, 2018 to be effective from

January 01, 2019. Accordingly, new licenses would be

issued i.e. Global Business Corporation (“GBC”) and

Authorised Company (“AC”). The license requirements

stipulate core income generating activities to be carried

out by the GBC namely: (i) employing, either directly

or indirectly, a reasonable number of suitably qualified

persons to carry out the core activities; and (ii) having a

minimum level of expenditure, which is proportionate

to its level of activities. While determining the same,

the FSC will take into consideration the nature and

level of core income generating activities conducted

(including the use of technology) by the GBC. The FSC

also provided indicative guidelines for determining

what would constitute as “a reasonable number

of suitably qualified persons” and “a minimum

expenditure which is proportionate to its level of

activities”. Further, in order to qualify for tax holidays

under the Mauritius Income Tax Act, the FSC also




7

stipulated that the licensees would require to possess

a physical office and also specified the minimum

number of employees which should be resident in

Mauritius and also minimum amount of annual

operating expenditure that should be incurred in

Mauritius or assets to be under their management

depending on the type of office.

B. Singapore

Singapore is one of the more advanced holding

company jurisdictions in the Asia-Pacific region.

Singapore possesses an established capital markets

regime that is beneficial from the perspective of

listing a fund on the Singapore stock exchange.

Further, the availability of talent pool of investment

professionals makes it easier to employ / relocate

productive personnel in Singapore.

During April – June 2018, India received the highest

FDI from Singapore of USD 6.52 billion.7 India and

Singapore are poised to see enhanced economic

cooperation as well as an increase in trade and

investment flows. This is well reflected from the fact

Singapore was the top source of FDI into India for

the second consecutive financial year, accounting for

about 30 per cent of FDI inflows in 2019-20.8 In the

last financial year, India attracted USD 14.67 billion

in FDI from Singapore.9 Singapore recently launched

the Variable Capital Companies (“VCC”) framework

on January 14, 2020, to constitute investment funds

across traditional and alternative strategies. A

significant chapter in propelling Singapore as an

international fund management and domiciliation

hub, VCCs provide fund managers with greater

flexibility on the domiciliation of extensive range

of investment funds. The provision of operational

flexibility and cost savings has become an enticing

factor for the Indian fund managers to set up offshore

fund in the VCC form, giving Singapore a distinct

advantage which in turn will lead to the development

of the overall fund management industry in Singapore.

7. https://dipp.gov.in/sites/default/files/FDI_FactSheet_23August2018.pdf.

8. https://www.ibef.org/news/singapore-top-source-of-fdi-in-fy20-with-investments-worth-us-1467-billion.

9. https://dipp.gov.in/sites/default/files/FDI_Factsheet_March20_28May_2020.pdf.

The India-Singapore DTAA, was co-terminus with

the India-Mauritius DTAA, hence exemptions

under the India-Singapore DTAA would continue

to be applicable till such benefits were available

under the India-Mauritius DTAA. Subsequent to

the India-Mauritius DTAA being amended, India

and Singapore also signed a protocol on December

30, 2016 to amend the India-Singapore DTAA. The

amendments introduced were largely along the lines

of those introduced under the India- Mauritius DTAA,

wherein the fundamental change was to provide for

source base taxation of capital gains arising out of

sale of Indian shares held by Singapore residents as

opposed to residence based taxation for the same.

Singapore does not impose tax on capital gains. Gains

from the disposal of investments may however, be

construed to be of an income nature and subject to

Singapore income tax. Generally, gains on disposal

of investments are considered income in nature

and sourced in Singapore if they arise from or are

otherwise connected with the activities of a trade or

business carried on in Singapore. As the investment

and divestment of assets by the Singapore based

entity are managed by a manager, the entity may be

construed to be carrying on a trade or business in

Singapore. Accordingly, the income derived by the

Singapore based entity may be considered income

accruing in or derived from Singapore and subject to

Singapore income tax, unless the Singapore based

fund is approved under Section 13R and Section 13X

respectively of the Singapore Income Tax Act (Chapter

134) (“SITA”) and the Income Tax (Exemption of

Income of Approved Companies Arising from Funds

Managed by Fund Manager in Singapore) Regulations,

2010. Under these Tax Exemption Schemes, “specified

income” derived by an “approved company” from

“designated investments” managed in Singapore by a

fund manager are exempt from Singapore income tax.

For fund managers considering Singapore resident

structures, a combination of Singapore resident

investment funds and Special Purpose Vehicles

(“SPV”) can be considered, given the tax exemption

schemes and the tax proposals for the companies

under the domestic law.

The protocol to the India-Singapore DTAA inserted

Article 28A to the DTAA which reads:

https://dipp.gov.in/sites/default/files/FDI_FactSheet_23August2018.pdf.

https://dipp.gov.in/sites/default/files/FDI_FactSheet_23August2018.pdf.

https://www.ibef.org/news/singapore-top-source-of-fdi-in-fy20-with-investments-worth-us-1467-billion.

https://www.ibef.org/news/singapore-top-source-of-fdi-in-fy20-with-investments-worth-us-1467-billion.

https://dipp.gov.in/sites/default/files/FDI_Factsheet_March20_28May_2020.pdf.

https://dipp.gov.in/sites/default/files/FDI_Factsheet_March20_28May_2020.pdf.



8

“This Agreement shall not prevent a Contracting State

from applying its domestic law and measures concerning

the prevention of tax avoidance or tax evasion.”

The language of the newly inserted Article 28A made

it clear that the Government of India (“GoI”) sees the

GAAR as being applicable even to situations where

a specific anti-avoidance provision (such as an LoB

clause) may already exist in a DTAA. Interestingly,

similar language was not introduced by the Protocol

to the India-Mauritius DTAA.

Making the GAAR applicable to companies that

meet the requirements of a LoB clause is likely to

adversely impact investor sentiment. Further, India-

Singapore DTAA has been notified as a CTA and

accordingly, the LoB clause contained in Article 24A

of the India-Singapore DTAA would be superseded

by the PPT. Demonstration of commercial substance

would be imperative to claim benefits under the

India-Singapore DTAA.

C. Ireland

Ireland is a tax-efficient jurisdiction when investment

into the Indian company is in the form of debt or

convertible debt instrument. Interest, royalties and

fees for technical services (“FTS”) arising in India and

paid to an Irish resident may be subject to a lower

withholding tax of 10% under the India-Ireland DTAA.

This is a significant relief from the withholding under

Indian domestic law which can be as high as 42% for

interest and around 27% for royalties and FTS.

Ireland can, therefore, be explored for debt funds or

real estate funds that provide structured debt and

also film funds that provide production financing

for motion pictures where cash flows received

from distributors could be in the nature of royalties.

However, the characterization of income would need

to be assessed on a case-by-case basis.

However, the changes introduced by the protocols to

the India-Mauritius and India-Singapore DTAA on

taxation of interest income (as summarized above)

make Mauritius and Singapore favorable choice

of jurisdictions even for debt funds. The costs of

setting-up in Mauritius or Singapore are likely to be

less expensive than Ireland.

D. Netherlands

With its robust network of income tax treaties,

Netherlands is an established international fund domicile.

In the context of inbound investments to India,

Netherlands emerges as an efficient jurisdiction for

making portfolio investments. In certain situations,

the India-Netherlands DTAA provides relief against

capital gains tax in India (that follows a source based

rule for taxation of capital gains). Gains arising to a

Dutch resident arising from the sale of shares of an

Indian company to non-resident buyer would not

be taxable in India. However, such gains would be

taxable if the Dutch resident holds more than 10%

of the shares of the Indian company in case of sale to

Indian residents. Even though the eligible holding is

capped, the same structure works well for FPIs, who

are restricted to invest (whether directly or indirectly

or synthetically through ODIs) up to 10% of the

paid-up capital of an Indian company, collectively

with their investor group or related FPIs.

For a Dutch entity to be entitled to relief under the

India-Netherlands DTAA, it has to be liable to pay

tax in the Netherlands. This may not be an issue for

entities such as Dutch limited liability companies

(BVs), public companies (NVs) or Cooperatives

investing or doing business in India.

In the case of KSPG Netherlands,10 it was held that

sale of shares of an Indian company by a Dutch

holding company to a non-resident would not be

taxable in India under the India- Netherlands DTAA.

It was further held that the Dutch entity was a

resident of the Netherlands and could not be treated

as a conduit that lacked beneficial ownership over

the Indian investments. The mere fact that the Dutch

holding company was set up by its German parent

company did not imply that it was not eligible to

benefits under the Netherlands-India DTAA.

It may be noted that difficulties with respect to treaty

relief may be faced in certain situations, especially in the

case of general partnerships and hybrid entities such as

closed limited partnerships, European economic interest

groupings (“EEIG”) and other fiscally transparent entities.

10. [2010] 322 ITR 696 (AAR).




9

3. Structural Alternatives for India-Focused Funds

I. Structuring India focused Offshore Funds

Private equity and venture capital funds typically

adopt one of the following three modes when

investing into India: (1) direct investment in the

Indian portfolio company, (2) direct or indirect

investment in an Indian investment fund vehicle,

or (3) co-investment along-side the domestic fund

vehicle directly in the Indian portfolio company.

(4) investment through an AIF set-up in IFSC. We

explore all three models in the brief below.

II. Foreign Investment Regimes

India’s exchange control regime is set out within

the FEMA and the rules and regulations thereunder.

FEMA regulates all inbound and outbound foreign

exchange related transactions, in effect regulating (or

managing) the capital flows coming into and moving

out of the country. Subject to certain conditions, such

as pricing restrictions, in most industry sectors, if

the percentage of equity holding by non- residents

does not exceed certain industry- specific thresholds

(sectoral caps) then FDI does not require prior GoI

approval. However, FDI requires prior GoI approval

by the concerned ministry/ department if it is in

excess of sectoral caps, is in breach of specified

conditions or is made in a sector which specifically

requires the approval.

The RBI is given primary authority to regulate capital

flows through the FEMA. Notably, Section 6 of FEMA

authorises the RBI to manage foreign exchange

transactions and capital flows in consultation with

the Ministry of Finance pursuant to the TISPRO

Regulations. These TISPRO Regulations were later

superseded by NDI Rules and the DI Regulations.

The primary routes for foreign investment into India

are (a) the FDI11 route, (b) FVCI12 route and the (c)

FPI13 route. In a bid to simplify and rationalize the FPI

regime, SEBI repealed the erstwhile FPI Regulations

2014 and introduced the FPI Regulations 2019. Based

on the regulatory status and jurisdiction of residence,

the FPI Regulations 2019 seek to simply the regime

for foreign portfolio investments in India, and places

greater emphasis on the classification of countries or

jurisdictions by the FATF, by prescribing eligibility

criteria for registration as a FPI. The new regulations

classify FPIs into two categories instead of three,

in addition to facilitating rules for investments in

offshore derivative instruments.

A. Pure Offshore Structure

A pure offshore structure is used where there is no

intent to pool capital at the domestic (i.e. India) level.

Under this structure, a pooling vehicle (Offshore

Fund) can be set up in an offshore jurisdiction.

Offshore investors will commit capital to the Offshore

Fund which in turn will make investments into

Indian portfolio companies (under one or more of the

inbound investment regimes mentioned above) as

and when investment opportunities arise.

11. This refers to investment through capital instruments by a person resident outside India in an unlisted Indian company; or in 10 percent or more of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company. While the RBI allows capital account transactions, these are subject to the NDI Rules. Thus, ‘direct’ investments by the offshore fund vehicles / SPVs (SPV would need to comply with the provisions and restrictions stipulated under the NDI Rules.

12. Given that the FVCI regime has been developed to attract venture capitalists, there are certain incentives attached to being recognised as one. This accordingly requires registration and approval from the regulators (SEBI and RBI). While granting approval to an FVCI, certain restrictions and conditions may be imposed including a restriction on the scope of investments that can be made by the FVCI. The RBI has recently been prescribing in its approval letter to FVCI applicants that the investments by FVCI entities are restricted to select identified sectors (which include, inter alia, infrastructure, biotechnology and IT related to hardware and software development). However, RBI has relaxed such sectoral restrictions for investing FVCIs into “startups’ (as defined in the relevant amendment to NDI Rules). It is also important to note that SEBI-registered FVCIs are specifically exempted from the RBI pricing guidelines.

13. The FPI Regulations classify FPIs into three categories based on their perceived risk profile. The FPI route as such is the preferred route for foreign investors who want to make portfolio investments and trade in Indian listed stocks on the floor of the stock exchange.



10

The following diagram depicts a pure offshore structure:

Under this structure, a trust or an LLP or a company (i.e., the “Onshore Fund”) is formed in India. The domestic

investors would directly contribute to the Onshore Fund whereas overseas investors will pool their investments

in an offshore vehicle (“Offshore Fund”) which, in turn, invests in the Onshore Fund. The Onshore Fund

could be registered with SEBI under the Securities and Exchange Board of India (Alternative Investment Funds)

Regulations, 2012 (“AIF Regulations”). The unified structure has received a big boost as general permission has

been granted under the FDI Policy to accept foreign investment in an AIF under the automatic route.

Offshore Investors

Offshore Fund

Eligible Investment

Investment Manager

Investment Advisor

Management Services

Advisory Services

SubscriptionAgreement

Offshore Investors

Offshore Fund

Eligible Investment

Investment Manager

Investment AdvisorManagement Services

Advisory

Services

SubscriptionAgreement

B. Unified Investment Structure

A unified structure is generally used where commitments from both domestic and offshore investors are pooled

into a domestic pooling vehicle (Onshore Fund). Alternatively, the unified structure can also be adopted by an

India based management team that seeks to extract management fee and carry allocations for the entire structure

at the Onshore Fund level.

The following diagram depicts a typical unified investment structure:




11

Favorable reasons for a unified structure

a. Non- applicability of foreign investment restrictions: Under the unified structure,

investments made by the Indian AIF with the

capital contributions received from the offshore

fund shall also be deemed to be domestic

investments if the manager and sponsor of the

AIF are Indian owned and controlled. Therefore,

the restrictions placed on foreign investments

such as FDI Policy related restrictions

including (a) sector specific caps (b) choice in

instruments being limited to equity shares, fully,

compulsorily convertible debentures and fully,

compulsorily and mandatorily convertible

preference (c) optionality clauses being subject

to conditions (d) pricing guidelines, etc. shall

not be applicable to the investments made in

India through the unified platform (which

would have been otherwise applicable in

respect of investments directly made by the

offshore fund in Indian opportunities).

b. Consolidation of corpus: A unified structure

allows aggregation of the asset- under

management across both the offshore fund

and the Indian AIF. A larger corpus at the

Indian AIF level will help tap more capital

from those LPs whose commitments are linked

to the corpus of the Indian AIF and allow the

manager to evaluate larger deals as the portfolio

concentration requirements can be met using

the larger aggregate pool at the AIF level. In

this regard, it is important to understand the

differences between pooling offshore investors

directly into the Indian AIF versus a unified

structure. There is a consolidation of corpus

in both the cases, however, there are other

reasons for pooling offshore investors in an

offshore vehicle (i.e. unified structure) which

are summarized below: (i) In case investment

by offshore investors in the Indian AIF, each

offshore investor may be required to obtain a

PAN14 card from Indian income tax authorities

and file income tax returns in India; (ii) While

making distributions to offshore investors

under the direct structure, the AIF has to

14.



consider withholding tax rates in force between

India and the concerned country of each of

the relevant offshore investor. In case of the

feeder set up, the tax status of the feeder is to be

considered.

c. Tax pass-through and DTAA eligibility: Category I and Category II AIFs have been

accorded tax pass through status under the ITA,

i.e. the income received by a unit-holder through

the AIF will be chargeable to income-tax in the

same manner as if it were the income arising to

such unit-holder directly by the unit-holder.15

Accordingly, the tax liabilities of the offshore

fund will remain the same (as would be for

direct investments) under the unified structure.

The protocols to the India-Mauritius DTAA

and India-Singapore give India the right to tax

capital gains arising from the transfer of equity

shares. Despite the changes introduced by the

protocols, Mauritius and Singapore continue to

be favorable jurisdictions from a tax perspective

as Mauritius and Singapore would continue to

have the right to tax capital gains arising from

the transfer of non-convertible debentures,

compulsorily convertible debentures and

optionally convertible debentures (depending

on the terms of the conversion of the optionally

convertible debentures).

d. Favorable regime: The GoI wants to promote

onshore fund management activities. To

that end, the benefits which are being made

available to AIFs would also extend to the

offshore fund in a unified structure.

With amendments brought about by the Finance

Act, 2015 (the “2015 Act”) in relation to the

criteria for determining the tax residence of

companies incorporated outside India, a foreign

company should not be a tax resident of India

in a particular financial year if the company’s

POEM in that financial year is not located in India.

POEM has been defined to mean “a place where

key management and commercial decisions that

are necessary for the conduct of the business of

15. S. 115UB read with s. 10(23FBA), s. 10(23FBB) and s. 194LBB of theITA.

an entity as a whole are, in substance, made”. The

provisions in relation to POEM are applicable

from the financial year 2016-17.

e. Decision-making: Under the unified structure, the

offshore fund will make a principal investment-

related decision i.e. whether or not to invest in the

Indian AIF. The offshore fund may need to make

additional decisions if certain offshore / Indian

investments are required to be made directly by

the offshore fund. Since most of the decisions in

respect of the Indian AIF are to be taken by the

India based investment manager, risks such as

that of the offshore fund having a permanent

establishment or its POEM in India, are reduced.

C. Co-investment / ParallelInvestment Structure

A co-investment structure is adopted where the

commercial expectation is to raise separate pools

of capital for domestic investors and for offshore

investors. Accordingly, separate pooling vehicles

will need to be set up in India (i.e. Onshore Fund)

and in an offshore jurisdiction (Offshore Fund). The

Offshore Fund and the Onshore Fund typically have

separate management structures. The Onshore Fund

is managed by an India-based investment manager

which entity may provide recommendations on

investment opportunities to the management of the

Offshore Fund on a non-binding basis.

Typically, the co-investment ratio between the

Offshore Fund and the Onshore Fund is the ratio of

their undrawn capital commitments.

The co-investment structure allows independent

investments by the Offshore Fund and the Onshore

Fund on the basis of their undrawn commitments in

case the other runs out of dry powder. Further, it also

provides greater flexibility to Onshore Fund allowing

it to make investments irrespective of the Offshore

Fund’s ability to do so.

Certain tax risks exist in such a structure. The Onshore

Fund and the Offshore Fund may be taxed together in

India as an ‘association of persons’ (“AOP”) and thus,

suffer disproportionately higher tax rates.




13

The following diagram depicts a typical co- investment structure:

D. AIF established in IFSC

The GoI is encouraging investments through IFSC with the objective of inter alia onshoring the fund

management industry to India. The SEBI (International Financial Services Centre) Guidelines, 2015 (“SEBI (IFSC) Guidelines”) regulate activities in relation to AIFs operating in IFSC (“IFSC AIFS”). In November 2018, the

SEBI based on deliberations with the AIPAC and with other stakeholders had issued the operating guidelines for

IFSC AIFs (“Operating Guidelines”). The Operating Guidelines for IFSC AIF lay down investment conditions

and restrictions, registration requirements and compliance requirements for IFSC AIFs. The provisions of the

Operating Guidelines have been explained in further detail in section VI of this paper.



In this regard, several benefits have also been

provided to IFSC AIFs. These benefits inter-alia

include exemption from restriction for overseas

investment, exemption from GST on management

fees, exemption to non-resident investors from

obtaining PAN and filing of income-tax returns in

India, subject to fulfilment of certain conditions.

Several nuances are involved in structuring of

investment through IFSC AIF as IFSC AIFs are

considered as persons resident outside India from

foreign exchange perspective, while being considered

to be resident of India for tax purposes.

The following diagram represents a typical structure

for IFSC AIF:

III. Certain Tax Risks

Owing to the uncertain nature of Indian income-tax

laws, there are certain tax risks that may arise to an

offshore fund depending on the complexity of the

structure and the level of substance demonstrated by

the offshore fund. The following is a brief summary of

these tax risks:

A. Association of Persons (AOP) Risk

An AOP is a ‘person’ recognized under Section

2(31) of the ITA and is, therefore, a separate taxable

entity. The Supreme Court of India has held that in

order to constitute an AOP, persons must join in a

common purpose or common action and the object

of the association must be to produce income - it

is not enough for the persons to receive income

jointly. The Supreme Court has also held that the

question whether there is an AOP must be decided

upon the facts and circumstances of each case. The

Indian tax authorities may claim that the control

and management of an offshore Fund vests with




15

the domestic investment manager and therefore,

the offshore Fund and the onshore fund together

constitute an AOP. The consequence of constitution

of an AOP would primarily be that all assessments

would be conducted at the AOP level rather than

qua the beneficiaries of the onshore fund.

B. Indirect Transfer of CapitalAssets Risk

An amendment to the ITA had introduced a provision

for the levy of capital gains tax on income arising

from the transfer of shares / interest in a company /

entity organized outside India which derives, directly

or indirectly, its value substantially from the assets

located in India. Pursuant to the said amendment,

there is a possibility that Indian tax authorities may

seek to tax the transfer of the shares in an offshore

fund by investors outside India, or the redemption

of shares by investors, notwithstanding that there is

no transfer taking place in India, on the basis that

the shares of the offshore fund derive substantial

value from India.

However, Central Board of Direct Tax’s (“CBDT”)

through Circular no. 4 of 2015 (“2015 Circular”)

had clarified that a distribution of dividends by an

offshore company with the effect of underlying

Indian assets would not result in a tax liability since

it does not result in indirect transfer of shares that

derive their value substantially out of India.

The Finance Act, 2017 brought changes to clarify

that the indirect transfer tax provisions shall not

be applicable to an asset or capital asset that is

held directly / indirectly by way of investment

in a Category I or Category II FPI16 under the FPI

Regulations 2014. Further, due to the consolidation

of categories of FPIs under the FPI Regulations 2019,

the Budget this position was extended to Category I

FPIs under the FPI Regulations 2019. This resolved

concerns for a class of offshore funds which are

registered as a Category I or Category II FPIs (under

FPI Regulations 2014) / Category I FPIs (under FPI

Regulations 2019) as redemptions by investors at the

level of the fund shall not be subject to the indirect

16. Proviso to Explanation 5 to Section 9(1)(i).

transfer taxation. Further, in multitiered structures,

if the entity investing into India is a Category I

or Category II FPI (under FPI Regulations 2014) /

Category I FPIs (under FPI Regulations 2019), any

up-streaming of proceeds by way of redemption /

buyback will not be brought within the Indian tax net.

The clarifications were implemented retrospectively

from FY starting April 1, 2012, and therefore would

help bring about certainty on past transactions that

have been entered into by Category I and Category II

FPI entities (under FPI Regulations 2014) / Category I

FPIs (under FPI Regulations 2019).

In November 2017, the CBDT notified that the indirect

transfer provisions shall not apply to income arising

or accruing on account of redemption or buyback of

share held indirectly by a non-resident in the Category

I and Category II AIFs, venture capital company

or a venture capital fund, if it is in consequence of

transfer of share or securities held in India by such

funds and if such income is chargeable in India. Thus,

adverse effect of indirect transfer provisions has been

minimized by not taxing a non-resident for its capital

gain, in case it made through such funds.

C. GAAR Risk

A statutory GAAR came into effect from the financial

year beginning on April 01, 2017. GAAR, as it is

currently drafted, empowers tax authorities to

disregard or combine or re-characterize any part

or whole of a transaction / arrangement such that

the transaction / arrangement gets taxed on the

basis of its substance rather than its form if such

arrangement gets classified as an impermissible

avoidance arrangement (i.e. arrangement which is

not in arm’s length, misuses or abuse of tax laws, lacks

or is deemed to lack commercial substance or is not

carried out for bonafide purpose). This could result

in any tax benefit being denied, including denial of

DTAA benefits, shifting of residency of investors and

/ or re-characterization of capital gains income as any

other classification. The CBDT had clarified by way of a

circular17 that shares issued after March 31, 2017 upon

the conversion of compulsorily convertible preference

17. CBDT Circular No.7 of 2017 dated January 27, 2017



shares (“CCPS”) acquired prior to April 01, 2017 should

be grandfathered if the terms of the conversion were

finalized at the time of issuance of the CCPS.

D. Tax Exposure Owing toPermanent Establishment

In a unified investment model or a parallel

investment model, there could be a risk of the

onshore fund or the Indian investment manager

of the onshore fund being perceived to constitute

a permanent establishment of the offshore fund if

there is no evidence of independent decision-making

at the offshore fund level. The Finance Act, 2015

had changed the criteria for determining tax residence

of companies incorporated outside India. As per

the amended criteria, to ensure that the company is

not construed to be tax resident of India in a particular

financial year, the company’s place of effective

management or POEM in that financial year should

not be located in India. POEM has been defined to

mean “a place where key management and commercial

decisions that are necessary for the conduct of the

business of an entity as a whole are, in substance made”.

CBDT had notified the final POEM guidelines18 which

emphasize that the test of POEM is one of substance

over form and will depend on facts and circumstances

of each case. Further, the guidance laid down different

tests for companies with active and passive businesses

outside India.

The POEM for an active company is presumed to be

outside India if the majority of its board meetings

are held outside India. To determine the POEM of

passive companies, the persons who actually make

key management and commercial decisions for the

business as a whole will be identified, followed by

identifying the place where decisions are actually

taken. POEM came into effect from April 01, 2017.

18. Circular No. 6 of 2017




17

4. Alternative Investment Funds in India

I. Introduction

Before the emergence of the Venture Capital Private

Equity (“VCPE”) industry in India, entrepreneurs

primarily depended on private placements, public

offerings and lending by financial institutions for

raising capital. However, given the considerations

involved, these were not always the optimal means of

raising funds.

Following the introduction of the Securities and

Exchange Board of India (Venture Capital Funds)

Regulations (“VCF Regulations”) in 1996, the VCPE

industry successfully filled the gap between capital

requirements of fast-growing companies and funding

available from traditional sources such as banks, IPOs,

etc. The VCPE industry has also had a positive impact

on various stakeholders – providing much needed risk

capital and mentoring to entrepreneurs, improving the

stability, depth and quality of companies in the capital

markets, and offering risk-adjusted returns to investors.

The growth in Venture Capital (“VC”) funding in

India can be attributed to various factors. Once the

GoI started becoming more and more aware of the

benefits of the VC investments and the criticality for

the growth of the different sectors such as software

technology and internet, favorable regulations were

passed regarding the ability of various financial

institutions to invest in a venture capital fund

(“VCF”). Further, tax treatments for VCFs were

liberalized and procedures were simplified.

Subsequently, in 2012, SEBI took steps to completely

overhaul the regulatory framework for domestic

funds in India and introduced the AIF Regulations.

Among the main reasons cited by SEBI to highlight its

rationale behind introducing the AIF Regulations was

to recognize AIFs as a distinct asset class; promote start-

ups and early stage companies; to permit investment

strategies in the secondary markets; and to tie

concessions and incentives to investment restrictions.

Here it is relevant to note that SEBI has adopted a

practical grandfathering approach which provides

that funds that are already registered under the VCF

Regulations would continue to be governed by those

regulations including for the purpose of raising

commitments up to their targeted corpus. However,

existing venture capital funds are not permitted to

increase their targeted corpus. Further, new funds and

existing funds that are not registered under any regime

would need to be registered under the AIF Regulations.

II. Alternative InvestmentFunds

Subject to certain exceptions, the ambit of the AIF

Regulations is to regulate all forms of vehicles set up in

India for pooling of funds on a private placement basis.

To that extent, the AIF Regulations provide the bulwark

within which the Indian fund industry is to operate.

An AIF means any fund established or incorporated in

India in the form of a trust or a company or an LLP or

a body corporate which:

a. is a privately pooled investment vehicle which

collects funds from investors, whether Indian

or foreign, for investing it in accordance with

a defined investment policy for the benefit of

its investors; and

b. is not covered under the Securities and Exchange

Board of India (Mutual Funds) Regulations,

1996, Securities and Exchange Board of India

(Collective Investment Schemes) Regulations,

1999 or any other regulations of the Board to

regulate fund management activities.19

III. Choice of Pooling Vehicle

The AIF Regulations contemplate the establishment of

funds in the form of a trust, a company, an LLP or a body

corporate. The following table provides a comparison of

these entities from an investment fund perspective:

19. SEBI (AIF) Regulations, 2012, Section 2 (1)(b)



Issue Trust Limited Liability Partnership

Company

General The person who reposes or declares the confidence is called the “author of the trust”20; the person who accepts the confidence is called the “trustee”; the person for whose benefit the confidence is accepted is called the “beneficiary”; the subject matter of the trust is called “trust property”; the

“beneficial interest” or “interest” of the beneficiary is the right against the trustee as owner of the trust property; and the instrument, if any, by which the trust is declared is called the

“instrument of trust”/ “indenture of trust”

The concept of LLP was recently introduced in India under the LLP Act. An LLP is a hybrid form of a corporate entity, which combines features of an existing partnership firm and a limited liability company (i.e. the benefits of limited liability for partners with flexibility to organize internal management based on mutual agreement amongst the partners).

The functioning of an LLP is governed by the LLP agreement.

A Company can be incorporated under the Companies Act, 2013.

The control of the company is with board of directors who are elected by the shareholders.

Separate classes of securities could be issued to different shareholders that shall determine their rights and obligations (as distinct from other classes) from both, the ‘voting’ perspective as well as from a ‘distribution’ perspective. The class structure, however, would need to be in compliance with Companies Act, 2013, as and when all relevant sections thereof are brought into effect.

Entities Involved The Settlor: The Settlor settles a trust with an initial settlement. Terms of the indenture of trust (“Indenture”) shall administer the functioning of the trust (“Trust”).

The Trustee: The Trustee is in charge of the overall administration of the Trust and may be entitled to a trusteeship fee. The Trustee may also appoint an investment manager, who in turn manages the assets of the Trust and the schemes / funds as may be launched under such Trust from time to time.

The Contributor: The contributor is the investor to the Trust (the Fund) and makes a capital commitment under a contribution agreement.

Partner: A ‘partner’ represents an investor in the fund. To that extent, a partner has an obligation to fund its ‘commitment’ to the fund and is entitled to distributions based on fund documents (being the LLP Agreement in this case).

Designated Partner: Though the expression ‘designated partner’ is not explicitly defined, however, on a plain reading of the LLP it is under- stood that such ‘designated partner shall be the person responsible and liable in respect of the compliances stipulated for the LLP.

Shareholders: Shareholders hold the shares of the company and are granted special privileges depending on the class of shares they own

Directors: Directors have a fiduciary duty towards the company with respect to the powers conferred on them by the Companies Act, 2013 and by the Memorandum of Association and Articles of Association of the company. They are trustees in respect of powers of the company that are conferred upon them, for instance, powers of (a) issuing and allotting shares; (b) approving transfers of shares; (c) making calls on shares; and (d) forfeiting shares for non-payment of call etc. They must act bona fide and exercise these powers solely for the benefit of the company.

Management of entities

The Trustee is responsible for the overall management of the Trust. In practice this responsibility is outsourced to an investment manager pursuant to an investment management agreement.

The LLP relies on the Designated Partner in this respect. In practice, this responsibility may be outsourced to an investment manager pursuant to an investment management agreement.

The board of directors manages the company involved. In practice this responsibility is outsourced to an investment manager pursuant to an investment management agreement.

20. Commonly referred to as a ‘settlor’




19

Market Practice Almost all funds formed in India use this structure.

The regulatory framework governing trust structures is stable and allows the management to write its own standard of governance.

Only a few funds are registered under this structure. The Registrar of Companies (“RoC”) does not favor providing approvals to investment LLPs.

As per section 5 of the LLP Act, 2008, only an individual or a body corporate is eligible to be a partner in an LLP.

There are no clear precedents for raising funds in a ‘company’ format.

The following diagram depicts an AIF that is set up in

the form of a trust:

IV. Classification of AIFs

As mentioned previously in our introductory chapter,

the AIF Regulations were introduced with the

objective of effectively channelizing incentives. For

this purpose, the AIF Regulations define different

categories of funds with the intent to distinguish

the investment criteria and relevant regulatory

concessions that may be allowed to them.

A description of the various categories of AIFs along

with the investment conditions and restriction

relevant to each category is summarized below:

1. AIFs may invest in securities of companies

incorporated outside India subject to such

conditions / guidelines that may be stipulated by

SEBI or the RBI;

2. Co-investment in an investee company by a

Manager / Sponsor should not be on more

favourable terms than those offered to the AIF;

3. Only a specific percentage of the investible

funds (25% for Category I and II AIFs and 10%

for Category III AIFs) can be invested in a single

investee company; remain locked-in the fund

until distributions have been made to all the other

investors in the fund. For a Category I or Category



II AIF, the sponsor or the manager is required

to have a continuing interest of 2.5% of the

corpus of the fund or INR 50 million whichever

is lower and in the case of a Category – III AIF, a

continuing interest of 5% of the corpus or INR

100 million whichever is lower. For the newly

introduced requirements as may be required.

The following is the list of general investment

conditions applicable to all AIFs:

a. AIFs should not invest in associates except with

the approval of 75% of investors by value of

their investments in the AIF; and

b. The un-invested portion of the investible funds

may be invested in liquid mutual funds or bank

deposits or other liquid assets of higher quality

such as Treasury

Category I AIF Category II AIF Category III AIF

i. Category I AIFs are funds with strategies to invest instart-up or early stage ventures or social venturesor SMEs or infrastructure or other sectors or areaswhich the government or regulators consider associally or economically desirable.

ii. Under the AIF Regulations, the following funds aredesignated as sub- categories of Category I AIFs -venture capital funds, SME funds, social venturefunds, infrastructure funds and such other AIFsas may be specified. In September 2013, SEBIintroduced ‘angel investment funds’ as a sub-classof the venture capital fund sub- category.

iii. AIFs which are generally perceived to have positivespillover effects on the economy and therefore, SEBI,the Government of India or other regulators mayconsider providing incentives

i. Category II AIFs are fundswhich cannot be categorizedas Category I AIFs orCategory III AIFs. Thesefunds do not undertakeleverage or borrowing otherthan to meet day-to-dayoperational requirementsand as permitted in the AIFRegulations.

ii. AIFs such as private equityfunds or debt funds forwhich no specific incentivesor concessions are givenby the Government of Indiaor any other regulator areincluded in the Category IIAIF classification.

i. Category III AIFs are fundswhich employ complex ordiverse trading strategiesand may employ leverageincluding through investmentin listed or unlistedderivatives.

ii. AIFs such as hedge fundsor funds which trade witha view to make short-termreturns or such other fundswhich are open endedand for which no specificincentives or concessionsare given by the Governmentof India or any other regulatorare included in the CategoryIII AIF classification.

V. Investment Conditionsand Restrictions underthe AIF Regulations

The AIF Regulations prescribe a general set of

investment restrictions that are applicable to all AIFs

and further prescribe a specific set of investment

restrictions that are applicable for each category of

AIFs. SEBI is authorized to specify additional criteria or




21

Investment Restrictions and Conditions for AIFs

Category I AIFs i. Category I AIFs shall invest in investee companies or venture capital undertakings or in specialpurpose vehicles or in limited liability partnerships or in units of other AIFs specified in theRegulations.

ii. A Category I AIF of a particular sub-category may invest in the units of the same sub- categoryof Category I AIFs. However, this investment condition is subject to the further restriction thatCategory I AIFs are not allowed to invest in the units of Fund of Funds.

iii. Category I AIFs shall not borrow funds directly or indirectly or engage in leverage except for meetingtemporary funding requirements for more than thirty days, on not more than four occasions in ayear and not more than 10% of its investible funds.

In addition to these investment conditions, the AIF Regulations also prescribe a set of investment conditions in respect of each sub-category of Category I AIFs.

Category II AIFs i. Category II AIFs shall invest primarily in unlisted investee companies or in units of other AIFs asmay be specified in the placement memorandum;

ii. Category II AIFs may invest in the units of Category I and Category II AIFs. This is subject to therestriction that Category II AIFs cannot invest in the units of Fund of Funds;

iii. Category II AIFs shall not borrow funds directly or indirectly or engage in leverage except formeeting temporary funding requirements for more than thirty days, on not more than fouroccasions in a year and not more than 10% of its investible funds;

iv. Category II AIFs may engage in hedging subject to such guidelines that may be prescribed by SEBI;

v. Category II AIFs may enter into an agreement with a merchant banker to subscribe to theunsubscribed portion of the issue or to receive or deliver securities in the process of marketmaking under Chapter XB of the ICDR Regulations; and

Category II AIFs shall be exempt from Regulations 3 and 3A of the Insider Trading Regulations in respect of investments in companies listed on SME exchange or SME segment of an exchange pursuant to due diligence of such companies. This is subject to the further conditions that the AIF must disclose any acquisition / dealing within 2 days to the stock exchanges where the investee company is listed and such investment will be locked in for a period of 1 year from the date of investment.

Category III AIFs i. Category III AIFs may invest in securities of listed or unlisted investee companies or derivatives orcomplex or structured products;

ii. Category III AIFs may deal in ‘goods’ received in delivery against physical settlement of commodityderivatives whereby ‘goods’ refers to those notified by the Central Government under Section2 (bc) of the Securities Contracts (Regulation) Act, 1956 and forming the underlying of anycommodity derivative;

iii. Funds of category III AIFs may invest in the units of Category I and Category II AIFs.

iv. This is subject to the restriction that Category III AIFs cannot invest in the units of Fund of Funds;

v. Category III AIFs engage in leverage or borrow subject to consent from investors in the fund andsubject to a maximum limit as may be specified by SEBI; and

Category III AIFs shall be regulated through issuance of directions by SEBI regarding areas such as operational standards, conduct of business rules, prudential requirements, restrictions on redemption and conflict of interest.



Bills, Collateralized Borrowing and Lending

Obligations (“CBLOs”), commercial papers,

certificates of deposits, etc. till deployment of

funds as per the investment objective

The following table summarizes the investment

restrictions that are applicable in respect of the

various categories of AIFs:

VI. Key Themes under theAIF Regulations

A. Continuing Interest

The AIF Regulations require the sponsor or the

manager of an AIF to contribute a certain amount

of capital to the fund. The purpose of the clause is

to have the sponsor or the investment manager to

commit capital to the funds (i.e.to have skin-in-the

game).This portion is known as the continuing

interest and will remain locked-in the fund until

distributions have been made to all the other

investors in the fund. For a Category I or Category II

AIF, the sponsor or the manager is required to have a

continuing interest of 2.5% of the corpus of the fund

or INR 50 million whichever is lower and in the case

of a Category – III AIF, a continuing interest of 5% of

the corpus or INR 100 million whichever is lower. For

the newly introduced angel investment funds, the

AIF Regulations require the sponsor or the manager

to have a continuing interest of 2.5% of the corpus of

the fund or INR 5 million whichever is lower. Further,

the sponsor or the manager (as the case may be) is

required to disclose its investment in an AIF to the

investors of the AIF.

B. Minimum Corpus

The AIF Regulations prescribe that the minimum

corpus for any AIF shall be INR 200 million

(“Minimum Corpus”). Corpus is the total amount

of funds committed by investors to the fund by way

of written contract or any such document as on a

particular date. By its circular dated on June 19, 2014,

(“Circular”) SEBI requires that where the corpus of an

open-ended scheme falls below the Minimum Corpus

(post redemption(s) by investors or exits), the Fund

Manager is given a period of 3 months to restore the

Minimum Corpus, failing which, all the interests of

the investors will need to be mandatorily redeemed.

C. Minimum Investment

The AIF Regulations do not permit an AIF to

accept an investment of less than INR 10 million

(“Minimum Investment Amount”) from any

investor unless such investor is an employee or a

director of the AIF or an employee or director of the

manager of the AIF in which case the AIF can accept

investments of a minimum value of INR 2.5 million.

The Circular has specifically clarified that in case of

an open-ended AIF, the first lump-sum investment

received from an investor should not be less than the

Minimum Investment Amount.21 Further, in case

of partial redemption of units by an investor in an

open- ended AIF, the amount of investment retained

by the investor should not fall below the Minimum

Investment Amount.22

D. Qualified Investors

The AIF Regulations permit an AIF to raise funds from

any investor whether Indian, foreign or non-resident

through the issue of units of the AIF. An AIF may

accept the following as joint investors for the purpose

of investment of not less than one crore rupees23:

i. an investor and his/her spouse

ii. an investor and his/her parent

iii. an investor and his/her daughter/son

With respect to the above investors, not more than 2

persons shall act as joint-investors in an AIF. In case of

any other investors acting as joint investors, for every

investor, the minimum investment amount of one

crore rupees shall apply. Joint investors shall mean

where each of the investor contributes towards the AIF.

21. CIR/IMD/DF/14/2014

22. Ibid.

23. Circular no. CIR/IMD/DF/14/2014 dated June 19, 2014




23

E. Foreign investment in AIFs

The NDI Rules defines an ‘Investment Vehicle’

to, inter-alia, mean an AIFs governed by the AIF

Regulations. The NDI Rules permits a person resident

outside India, other than a citizen of Bangladesh or

Pakistan or an entity incorporated in Bangladesh

or Pakistan, to invest in units of an Investment

Vehicle, in the manner and subject to the terms and

conditions specified in Schedule VIII of the NDI Rules.

The NDI Rules lay down certain terms and conditions

governing investments in such Investment Vehicles

in the manner as follows:

§ A person resident outside India who has acquired

or purchased units in accordance with Schedule

VIII may sell or transfer in any manner or redeem

the units as per regulations framed by Securities

and Exchange Board of India or directions issued

by the Reserve Bank.

§ An Investment vehicle may issue its units to

a person resident outside India against swap

of capital instruments of a SPV proposed to be

acquired by such Investment Vehicle.

§ Investment made by an Investment Vehicle into

an Indian entity shall be reckoned as indirect

foreign investment for the investee Indian entity

if the sponsor or the manager or the investment

manager (i) is not owned and not controlled

by resident Indian citizens or (ii) is owned or

controlled by persons resident outside India.

Provided that for sponsors or managers or investment

managers organized in a form other than companies

or LLPs, Securities and Exchange Board of India

shall determine whether the sponsor or manager or

investment manager is foreign owned and controlled.

Explanation: ‘Control’ of the AIF should be in the

hands of ‘sponsors’ and ‘managers/ investment

managers’, with the general exclusion to others.

In case the ‘sponsors and ‘managers/ investment

managers’ of the AIF are individuals, for the treatment

of downstream investment by such AIF as domestic,

‘sponsors’ and ‘managers/ investment managers’

should be resident Indian citizens.

F. Maximum Number of Investors

The AIF Regulations caps the maximum number of

investors for an AIF at 1,000.

G. Private Placement

The AIF Regulations prohibit solicitation or collection

of funds except by way of private placement. While

the AIF Regulations do not prescribe any thresholds

or rules for private placement, guidance is taken from

the Companies Act, 2013.

H. Tenure

While Category I and Category II AIFs can only be

closed-end funds, Category III AIFs can be open-

ended. The AIF Regulations prescribe the minimum

tenure of 3 years for Category I and Category II

AIFs. SEBI, vide its circular dated October 01, 2015,24

clarified that the tenure of any scheme of the AIF

shall be calculated from the date of the final closing

of the scheme. Further, the tenure of any AIF can

be extended only with the approval of 2/3rd of the

unitholders by value of their investment in the AIF.

I. Overseas investments by AIFs

As per a circular dated October 1, 201525 issued by

SEBI, an AIF may invest in equity and equity- linked

instruments of off-shore VCUs, subject to certain

conditions mentioned in this circular such as an

overall aggregate limit of USD 500 million for all AIFs

and VCFs registered under the SEBI (Venture Capital

Funds) Regulations, 1996 and the guidelines stipulated

by the RBI in this respect. Investments would be

made only in those companies which have an Indian

connection (i.e. company which has a front office

overseas, while back office operations are in India) and

such investments would be up to 25% of the investible

funds of the AIF. The aforementioned circular clarifies

that an offshore VCU means a foreign company whose

shares are not listed on any of the recognized stock

exchange in India or abroad. Such an investment by an

AIF requires prior approval from SEBI. The allocation

24. Circular No. (CIR/IMD/DF/7/2015)

25. Ibid



24

of investment limits would be done on a ‘first come

first serve’ basis depending on availability in the overall

limit of USD 750 million, and in case an AIF fails to

make the allocated investment within a period of 6

months from date of approval, SEBI may allocate such

unutilized limit to another applicant.

J. Change in Circumstances

The Circular provides that in case any ‘material

change’ to the placement memorandum (changes that

SEBI believes to be significant enough to influence

the decision of the investor to continue to be invested

in the AIF), is said to have arisen in the event of (1)

change in sponsor / manager, (2) change in control of

sponsor / manager, (3) change in fee structure which

may result in higher fees being charged to the unit

holders and (4) change in fee structure or hurdle rate

which may result in higher fees being charged to the

unit holders. In case of such ‘material change’, the

existing investors who do not wish to continue post

the change shall be provided with an exit option and

such existing investors will be provided not less than

one month for indicating their dissent.

There are increasing examples of acquisitions of

fund management businesses by international and

domestic acquirers. The Circular becomes especially

relevant in navigating the regulatory landscape for

achieving such commercial transactions. Care must

also be taken to ensure a proper diligence of the

proposed target, not just from a company perspective,

but also from a legal, regulatory and tax perspective

vis-à-vis the funds manager by the target.

K. Operating Guidelines for Financial Services Centre AIFs set-up in International (IFSC)26

In pursuance of the SEBI IFSC Guidelines, SEBI issued

Operating Guidelines providing for the process with

respect to registration, compliance and restrictions

for setting up alternative investment funds in IFSC.

Accordingly, each scheme of an AIF would be required

to have a corpus of at least USD 3 million. Further,

26. Circular No. SEBI/HO/IMD/DF1/CIR/P/143/2018.

if the corpus of the AIF exceeds USD 70 million,

the sponsor or manager of the AIF (Category I and

Category II) would be required to appoint a custodian

registered with SEBI for safekeeping of securities.

The Operating Guidelines provided that the

minimum investment amount in the AIF would

be USD 150,000. Further, with respect to investors

who are employees or directors of the AIF or the

Investment Manager, the minimum investment

amount would be USD 40,000. The Operating

Guidelines require the Investment manager or

sponsor to possess a continuing interest of not less

than 2.5% of the corpus of the AIF or USD 750,000

whichever is lower in the AIF and such interest shall

not be through the waiver of management fees. With

respect to Category III AIFs, the manager or sponsor

would be required to invest not less than 5% of the

corpus of USD 1.5 million whichever is lower in the

AIF. The Operating Guidelines allow an AIF set up in

IFSC to invest in units of other AIFs set up in IFSC and

India subject to the AIF Regulations.

In addition to the above, the Operating Guidelines

permit a sponsor or investment manager of an

existing AIF in India to act as a sponsor or investment

manager of an AIF set up in IFSC by either setting up

a branch in IFSC or incorporating a company or LLP

in IFSC. However, the sponsor or manager to be set up

in IFSC would be required to incorporate a company

or LLP in IFSC.

With respect to angel funds, the Operating Guidelines

provide that the minimum corpus of an angel fund

shall be at least USD 750,000. The angel investor

investing in the angel fund set up in IFSC, must satisfy

the following conditions: (i) the angel investor should

possess net tangible assets of at least USD 300,000

excluding value of its principal residence; (ii) a body

corporate shall have a net worth of at least USD one

million five hundred thousand.

With respect to investment by angel funds setup in

IFSC into venture capital undertakings in India, the

investment should be not less than USD 40,000 and

should not exceed USD one million five hundred

thousand. Further, the venture capital undertakings

should have a turnover of less than USD three million

seven hundred and fifty thousand. Angel funds may




25

invest in venture capital undertakings which are not

promoted or sponsored by or related to an industrial

group whose group turnover exceeds USD 45 million.

The Manager or Sponsor of the angel fund should

have a continuing interest of not less than 2.5% of

the corpus of USD 80,000, whichever is lower and

such interest should not be through the waiver of

management fees.

L. Standardized PPM

SEBI recently introduced template(s) for PPM, subject

to certain exemptions, and mandatory performance

benchmarking for AIFs (other than angel funds,

and / or those falling under exemptions explained

below)with provisions for additional customized

performance reporting.27 This is in congruence with

SEBI’s initiative to streamline disclosure standards.

While the circular leaves ample scope for the parties to

give additional information, the mandatory template

provides for two parts: Part A – section for minimum

disclosures, and Part B – supplementary section to

allow full flexibility to the Fund in order to provide

any additional information, which it deems fit.

Two distinct templates have been specified by the

Circular, one for Category I and II AIFs and the other

for Category III AIFs.

In doing so, SEBI has also prescribed that the terms

of the contribution agreement shall not beyond the

terms of the private placement memorandum.

M. Audit of PPM

Furthermore, in order to ensure compliance with

the terms of PPM, the Circular has also made it

mandatory for AIFs (other than angel funds, and / or

those falling under exemptions explained below) to

carry out an annual audit of such compliance by an

internal or external auditor/legal professional. The

audit of sections of PPM relating to ‘Risk Factors’,

‘Legal, Regulatory and Tax Considerations’ and ‘Track

Record of First Time Managers’ shall be optional.

The findings of the audit, along with corrective

steps, if any, shall be communicated to the Trustee or

27. Circular No. SEBI/HO/IMD/DF6/CIR/P/2020/24, dated Feb 06, 2020.

Board or Designated Partners of the AIF, Board of the

Manager and SEBI. Such audit of compliance shall

be conducted at the end of each Financial Year and

the required parties have to be informed within six

months from the end of the Financial Year.28

However, SEBI has exempted Angel Funds and

AIFs/Schemes in which each investor commits to

a minimum capital contribution of INR 70 crores

(USD 10 million or equivalent, in case of capital

commitment in non-INR currency) from the

aforementioned compliances. Furthermore, the

requirement of audit of compliance with terms of

PPM shall not apply to AIFs which have not raised

any funds from their investors.

N. Performance Benchmarking

SEBI has also introduced mandatory benchmarking of

the performance of the AIFs and the AIF industry and

a framework for facilitating the use of data collected

by Benchmarking Agencies to provide customized

reports. Any association of AIFs (“Association”), which

in terms of membership, represents at least 33% of the

number of AIFs, may notify one or more Benchmarking

Agencies, with whom each AIF shall enter into an

agreement for carrying out the benchmarking process.

The agreement between the Benchmarking Agencies

and AIFs shall cover the mode and manner of data

reporting, specific data that needs to be reported, terms

including confidentiality in the manner in which the

data received by the Benchmarking Agencies may

be used, etc. AIFs, for all their schemes which have

completed at least one year from the date of ‘First

Close’, shall report all the necessary information

including scheme-wise valuation and cash flow data

to the Benchmarking Agencies in a timely manner.

The form and format of reporting shall be mutually

decided by the Association and the Benchmarking

Agencies. If an applicant claims a track-record on

the basis of India performance of funds incorporated

overseas, it shall also provide the data of the

investments of the said funds in Indian companies

to the Benchmarking Agencies, when they seek

registration as AIF.

28. Circular No.: SEBI/HO/IMD/DF6/CIR/P/2020/99, dated Jun12, 2020.



26

In the PPM, as well as in any marketing or promotional

or other material, where past performance of the AIF is

mentioned, the performance versus benchmark report

provided by the benchmarking agencies for such

AIF/Scheme shall also be provided. In any reporting

to the existing investors, if performance of the AIF/

Scheme is compared to any benchmark, a copy of the

performance versus benchmark report provided by

the Benchmarking Agency shall also be provided for

such AIF/scheme. SEBI has also issued the Operational

Guidelines in this regard.29

VII. Taxation of Alternative Investment Funds

A. Taxation of funds registered as Category I or Category II AIFs

In response to a long-standing demand of the

investment funds industry in India, the Finance Act,

2015, extended tax pass through status to AIFs that are

registered with SEBI as Category I AIFs or Category II

AIFs under the AIF Regulations.

Prior to the changes introduced by the Finance Act,

2015, only an AIF that was registered as a VCF sub-

category of Category I and VCF registered under the

VCF Regulations were eligible for the exemption

under section 10(23FB) of the ITA.

The Finance Act, 2015 included a proviso to section

10(23FB) of the ITA pursuant to which, Category I

and Category II AIFs that are registered under the AIF

Regulations, will be taxed according to the new rules

set forth in the newly introduced Chapter XII-FB of

the ITA. Consequently, VCFs registered under the

erstwhile VCF Regulations will continue to be eligible

to claim the exemption under section 10(23FB) in

respect of income from investments in venture

capital undertakings.

Investment Fund is defined under clause (a) of the

Explanation 1 to Section 115UB of the ITA as any

fund established or incorporated in India in the form

of a trust or a company or a LLP or a body corporate

29. https://www.sebi.gov.in/sebi_data/commondocs/feb-2020/ann_4_p.pdf

which has been granted a certificate of registration

as a Category I or a Category II AIF and is regulated

under the AIF Regulations.30 The ITA provides

that any income accruing or arising to, or received

by, a unit- holder of an investment fund out of

investments made in the investment fund shall be

chargeable to income- tax in the same manner as if

it were the income accruing or arising to, or received

by such person, had the investments made by the

investment fund been made directly by the unit-

holder.31 In other words, the income of a unit-holder

in an investment fund will take the character of the

income that accrues or arises to, or is received by the

investment fund.

The ITA contemplates that income chargeable under

the head ‘Profits and gains of business and profession’

will be taxed at the investment fund level and the tax

obligation will not pass through to the unitholders.

In order to achieve this, the Act has two provisions:

a. Section 10(23FBA) which exempts income of an

investment fund other than income chargeable

under the head ‘Profits and gains of business or

profession’; and

b. Section 10(23FBB) which exempts the proportion

of income accruing or arising to, or received by, a

unit-holder of an investment fund which is of the

same nature as income chargeable under the head

‘Profits and gains of business or profession’.

However, the CBDT vide its Circular No. 14/2019

dated July 03, 2019 has clarified that the income in

the hands of non-resident investor from offshore

investments routed through Category-I / Category-II

AIFs shall not be liable to tax in India, being a deemed

direct investment made outside India by such non-

resident investor.

In case, the exemption under section 10(23FBA) is

denied to the Fund, then the income of the Fund

should be subject to tax as per the general principles of

taxation of trusts under sections 161 to 164 of the ITA.

Furthermore, the CBDT has notified that income

received by investment funds would be exempted

30. Explanation 1 to Section 115UB of the ITA.

31. Vide Notification No. 51 / 2015 dated June, 2015.




27

from TDS by portfolio companies. This should

be helpful in case of interest / coupon payouts by

portfolio companies to such funds. Previously, it was

administratively difficult for investors to take credit

of the TDS withheld by portfolio companies.

An important feature of the pass-through framework

was the requirement to deduct tax at 10% on the

income that is payable to the payee as outlined in

the newly section 194LBB of the ITA. In view of the

rule mandating the deemed credit of income to

the accounts of unit-holders, the Finance Act, 2015

extended the requirement to deduct tax to scenarios

where income is not actually paid or credited but only

deemed to be credited.

The Finance Act, 2016 has amended section 194(LBB)

of the ITA to enable deduction of withholding tax for

non-residents at a rate which is in accordance with

the provisions of the DTAA if they are eligible to

DTAA benefits. However, it keeps the withholding

rate unchanged for resident investors.

The only relief that is available to resident investors

is that they are allowed to approach the revenue

authorities for a reduced or a nil withholding

certificate under section 197 of the ITA if they are

entitled to any benefits as per their tax status or due to

the stream of income that is being distributed by the

investment fund.

Traditionally, the issue of characterisation of exit

gains (whether taxable as business income or capital

gains) has been a subject matter of litigation with the

Indian Revenue authorities. CBDT vide Instruction

No. F.No. 225/12/2016/ ITA.II dated May 02, 2016

has clarified that it has given directions to officers in

relation to determining the tax treatment of income

arising from transfer of unlisted shares wherein it

has decided that income arising from transfer of

unlisted shares would be taxed as capital gains under

the ITA irrespective of the period of holding. This

would however, not be applied in situations where

(i) the genuineness of transactions in unlisted shares

itself is questionable; or (ii) the transfer of unlisted

shares is related to an issue pertaining to lifting of

corporate veil; or (iii) the transfer of unlisted shares

is made along with the control and management

of underlying business and the Indian revenue

authorities would take appropriate view in such

situations.

In this regard, CBDT has issued a subsequent

clarification dated January 24, 2017 (CBDT

F.No.225/12/2016/ITA.II) stating that the exception

to transfer of unlisted securities made along with

control and management of underlying business

would not apply to Category I & II AIFs.

In case the income of the investment fund is

characterized as business income, then income in

the nature of profits and gains of business should

be subject to tax at the investment fund level at the

applicable maximum marginal rate. The same should

be exempt from tax in the hands of the beneficiaries.

With respect to the losses incurred by such AIFs,

whether in the nature of business losses or otherwise,

the earlier provisions provided that can only be set-

off or carried forward by such AIFs and not by the

unitholders. Until now, losses suffered by such AIFs

(not being in the nature of business losses) could not

be passed through to its investors for them to claim

set-off of such losses against income earned by them.

The Finance Act, 2019 has amended Section 115UB

to allow losses incurred by such AIFs (not being in

the nature of business losses) to be passed through

to its investors to be able to set-off or carry forward

such losses while computing their income. However,

in order to avail such pass-through benefit, such

investors should have held units in the AIF for a

period of more than twelve months. It is also provided

that business losses incurred by the investment fund

will be retained at the level of the investment fund

and not be available for offset to investors; instead,

such losses must be offset by the investment fund

against subsequent business income, if any.

The Budget inserted Section 10(23FE) whereby any

income in the nature of dividend, interest or long-term

capital gain arising from an investment made in India

by (i) wholly owned subsidiary of ADIA being a resident

of the UAE; (ii) any foreign sovereign wealth fund; (iii)

any foreign pension fund, have been exempted wherein

the investment is made on or after 1 April 2020 but on

or before the 31 March 2024 and held for at least 3 years.

Such investments shall be made in the form of debt or

share capital or unit, in the following entities:



28

a. a business trust (registered as InvITs or REITs); or

b. an infrastructure entity; or

c. Category I or Category II of AIF (having 100%

investment in infrastructure entity).

The CBDT, vide a notification (44/2020/F. No.

370142/24/2020-TPL) dated 6th July, 2020, widened

the scope of ‘infrastructure’ for the purpose of

claiming income tax exemption under Section 10

(23FE) of the ITA. The Notification has extended the

benefits of the exemption to the sovereign wealth

funds and pension funds on their investment in

infrastructure sector.

B. Taxation of Category III AIFs

As mentioned earlier, AIFs are usually set up as

trusts and consequently they are subject to the

tax framework that is applicable to trusts in India.

Under Indian tax law, a trust is not a separate taxable

entity. Taxation of trusts is laid out in sections 161

to 164 of the ITA. Where the trust is specific, i.e., the

beneficiaries are identifiable with their shares being

determinate, the trustee is assessed as a representative

assessee and tax is levied on and recovered from them

in a like manner and to the same extent as it would

be leviable upon and recoverable from the person

represented by them.

In the case of AIG (In Re: Advance Ruling P. No. 10 of

1996), it was held that it is not required that the exact

share of the beneficiaries be specified for a trust to be

considered a determinate trust, and that if there is a

pre- determined formula by which distributions are

made the trust could still be considered a determinate

trust. The tax authorities can alternatively raise an

assessment on the beneficiaries directly, but in no

case can the tax be collected twice over.

While the income tax officer is free to levy tax either

on the beneficiary or on the trustee in their capacity as

representative assessee, as per section 161 of the ITA,

it must be done in the same manner and to the same

extent that it would have been levied on the beneficiary.

Thus, in a case where the trustee is assessed as a

representative assessee, they would generally be able

to avail of all the benefits / deductions etc. available to

the beneficiary, with respect to that beneficiary’s share

of income. There is no further tax on the distribution of

income from a trust.

On July 28, 2014, CBDT issued a circular to provide

‘clarity’ on the taxation of AIFs that are registered

under the AIF Regulations.

The Circular states that if ‘the names of the investors’

or their ‘beneficial interests’ are not specified in the

trust deed on the ‘date of its creation’, the trust will be

liable to be taxed at the ‘maximum marginal rate’.

The Bangalore Income Tax Appellate Tribunal in the

case of DCIT v. India Advantage Fund – VII32 held that

income arising to a trust where the contributions

made by the contributors are revocable in nature,

shall be taxable at the hands of the contributors. The

ruling comes as a big positive for the Indian fund

industry. The ruling offers some degree of certainty

on the rules for taxation of domestic funds that are

set up in the format of a trust by regarding such

funds as fiscally neutral entities. Globally, funds

have been accorded pass through status to ensure

fiscal neutrality and investors are taxed based on

their status. This is especially relevant when certain

streams of income maybe tax free at investor level

due to the status of the investor, but taxable at fund

level. Funds, including AIFs that are not entitled

to pass through status from a tax perspective

(such as Category III AIFs) could seek to achieve a

pass-through basis of tax by ensuring that the capital

contributions made by the contributors is on a

revocable basis).

Further, the CBDT has issued a clarification (vide

Circular No. 6 of 2016 dated February 29, 2016) that

income arising from transfer of listed shares and

securities, which are held for more than 12 months

should be taxed as capital gains under the ITA unless

the tax-payer itself treats these as its stock-in-trade

and transfer thereof as its business income.

32. ITA No.178/Bang/2012




29

C. Taxation of Category III AIFs in IFSC

Recently, the GoI passed the Taxation and Other Laws

(Relaxation and Amendment of Certain Provisions)

Act, 2020 (“Taxation Act, 2020”)33 which seeks to

inter-alia amend the ITA and the Finance Act, 2020.

Amongst other amendments, the Taxation Act, 2020

provides tax incentives for Category-III AIFs located

in the IFSC (“Category-III IFSC AIFs”) and its

investors to encourage relocation of foreign funds

to the IFSC. The Taxation Act, 2020 provides for

certain categories of income to be exempted from the

levy of capital gains tax, in addition to certain other

categories which were already exempted.

These changes not only seek to bring Category-III

IFSC AIFs at par with FPIs, but also provide certain

33. The Taxation and Other Laws (Relaxation of Certain Provisions) Ordinance 2020 (“the Ordinance”) was promulgated on March 31, 2020, in order to ease compliance burden on taxpayers due to outbreak of COVID-19. The Taxation and Other Laws (Relaxations and Amendments of certain Provisions) Bill 2020 passed by Lok Sabha and Rajya Sabha seeks to replace the Ordinance. The Taxation Act, 2020 received assent from President of India on September 29, 2020

additional incentives for investing through IFSC. For

instance, while capital gains earned by FPIs on transfer

of debt securities or derivatives issued by Indian

companies is subject to tax in India, such income is

exempt from tax in case of Category-III IFSC AIFs.

Further, any income accruing or arising to or

received by unit holders from Category-III IFSC AIF

or on transfer of units in Category-III IFSC AIFs has

been exempted from tax.34 From the perspective

of investors, this exemption should ensure clarity

and reduce chances of litigation in relation to their

investment in Category-III IFSC AIFs.

The table below captures the tax rates (exclusive of

surcharge and cess) applicable to Category-III IFSC

AIFs vis-à-vis FPIs:

Nature of income Category-III IFSC AIFs (registered as FPI) FPIs

Dividend 10% 20%

Interest under section 194LD 5% 5%

Interest 10% 20%

Long-term capital gains (including LTCG under section 112A)

10% 10%

Short-term capital gains under section 111A

15% 15%

Other short-term capital gains 30% 30%

34. Section 10(23FBC) of the ITA



30

5. Trends In Private Equity

The standard of what constitutes an ‘alignment of

interests’ between fund investors (LPs) and fund

managers (GPs) of an India-focused fund or an

India- based fund has undergone some degree of

change over the years. Typically, LP participation in

a fund is marked by a more hands-on approach in

discussing and negotiating fund terms which by itself

is influenced by a more comprehensive due diligence

on the track record of the GP and the investment

management team.

As discussed briefly earlier, unified structures have

emerged as a preferred choice for structuring India

focused funds. There is also an increased participation

from DFIs in India focused funds, including unified

structures. Accordingly, some global benchmarks

need to be followed when designing the structure

and calibrating the fund documents including the

governance, fiduciary aspects and adherence to ESG

policies and AML policies. With one or more DFIs

or sovereign investors in the mix, the fund terms

continue reflecting a more LP tilt in balance even for

fund managers raising a series III or a Series IV fund.

There can be variations of a unified structure

depending on the investment strategy of the fund,

allocation of economics for the GP and certain legal

and regulatory considerations involving the LPs. In

addition to the above, there can be other variations

to the investment structure depending on the

commercials involved.

The overseas fund could directly invest in India based

opportunities or adopt a co-investment structure (i.e.

the offshore fund invests alongside the Indian fund in

eligible investment opportunities).

The FDI Policy will however be applicable to

investments made directly by an offshore fund in India.

An optimum structure should reconcile the investment

strategy, team economics and LP preferences.

New investment funds with more focused strategies

are seen coming up as India introduces favorable

policy and regulatory changes such as introduction

of the Insolvency and Bankruptcy Code, passing of a

single goods and services tax (“GST”), tax initiatives

for Small and Medium Enterprises, policy initiatives

for the insurance sector and increased focus on

technology driven payment mechanisms.

This chapter provides a brief overview of certain fund

terms that have been carefully negotiated between

LPs and GPs in the Indian funds context.

I. Trending fund terms

A. Investment Committee and Advisory Board

Sophisticated LPs insist on a robust decision- making

process whereby an investment manager will refer

investment and / or divestment proposals along

with any due diligence reports in respect of such

proposals to an investment committee comprising

representatives of the GP. The investment committee

has traditionally been authorized to take a final

decision in respect of the various proposals that are

referred to it. However, SEBI from time to time gives

feedback on such provisions. For example, lately

the feedback coming from SEBI is that Investment

Manager be responsible for all the binding

investment / divestment decisions and accordingly

any other entity, by whatever name called, can only

provide recommendations / inputs in the decision

making process. In view of this, the composition

of the investment committee and the nature of

rights granted to certain members can become

very contentious. In view of the composition of the

investment committee, the feedback received from

SEBI is that the investment committee should not

consist of external members and shall be comprised

by the internal members of the management entity.

The committee is also empowered to monitor the

performance of investments made by the fund a view

to limiting the quantum of expenses that are paid

by the fund, LPs insist on putting a cap on expenses.

The cap is generally expressed as a percentage of the

size of the fund or as a fixed number can become a




31

debatable issue depending on the investment strategy

and objective of the fund. GPs often try to negotiate

for annual caps for operating expenses, given the

long tenure of VC/PE funds and the difficulty in

ascertaining the appropriate cap for the entire tenure

upfront; whereas, LPs prefer a cap for the entire tenure

to be disclosed upfront in the fund documents. If an

annual cap method is chosen, LPs often seek the right

to be consulted before setting the annual cap by GPs.

Separately, as a measure of aligning interests, LPs

insist that allocations made from their capital

contributions towards the payment of expenses

should be included while computing the hurdle

return whereas the same should not be included

while determining management fee after the

commitment period.

Additionally, certain LPs also insist that specific

fund expenses associated with certain LPs must be

allocated to LPs only. For instance, if an investor

enters the fund through a placement agent, the

placement fees to be borne by the fund shall be

allocated from the capital contribution of the said

investor. The ratio of distributions is accordingly

expected follow the ratio of each investor’s

participation in the deals.

B. Waterfall

A typical distribution waterfall involves a return

of capital contribution, a preferred return (or a

hurdle return), a GP catch-up and a splitting of the

residual proceeds between the LPs and the GP. With

an increasing number of GPs having reconciled

themselves to the shift from the 20% carried interest

normal, a number of innovations to the distribution

mechanism have been evolved to improve

fundraising opportunities by differentiating product

offerings from one another. Waterfalls have been

structured to facilitate risk diversification by allowing

LPs to commit capital both on a deal-by- deal basis

as well as on a blind pool basis. Further, distribution

of carried interest has been structured on a staggered

basis such that the allocation of carry is proportionate

to the returns achieved by the fund.

In a unified structure, the distribution waterfall at

the Indian AIF level may require that distributions

to the Offshore Fund be grossed-up to the extent of

the expenses incurred at the Offshore Fund level.

The distribution proceeds at the Indian AIF level

could be allocated between the domestic investors

and the offshore fund providing them INR and USD

denominated preferred returns respectively.

While the taxation of carried interest remains unclear

globally, several Indian GPs are considering allowing

their employees (who are entitled to carry) to track

the carry directly from the fund, including through

structures such as employee welfare trusts.

C. Giveback

While there have been rare cases where some LPs

have successfully negotiated against the inclusion

of a giveback provision, GPs in the Indian funds

industry typically insist on an LP giveback clause to

provide for the vast risk of financial liability including

tax liability. The LP giveback facility is a variant to

creating reserves out of the distributable proceeds

of the fund in order to stop the clock / reduce the

hurdle return obligation. With a view to limiting the

giveback obligation, LPs may ask for a termination of

the giveback after the expiry of a certain time period

or a cap on the giveback amount. However, this may

not be very successful in an Indian context given that

the tax authorities are given relatively long time-

frames to proceed against taxpayers.

As bespoke terms continue to emerge in LP-GP

negotiations, designing a fund may not remain just

an exercise in structuring. The combination of an

environment less conducive for fund raising and

changes in legal, tax and regulatory environment

along with continuously shifting commercial

expectations requires that fund lawyers provide

creatively tailored structural alternatives.

There are certain India specific issues which may

complicate LP giveback negotiations beyond global

standards. For example, a Category I or II AIF in

India which is set up as a determinate trust could,

separately and in addition to the LP giveback clause,

seek a tax indemnity from each of its investors for

the AIF, its manager or its trustee doing good any tax

liability on behalf of any of such investors.



32

D. Voting rights

In a unified structure, the Indian AIF will issue

different classes of units / shares (as applicable) to

the domestic LPs and the offshore fund respectively

upon receiving their capital contributions. In respect

of issues where a vote is required to be cast by the

offshore fund in its capacity as an investor in the

Indian AIF, the board of the offshore fund may seek

the recommendations of its shareholders (i.e. the

offshore investors) on such matters and cast votes on

the units / shares (as applicable) of the Indian AIF in

a manner reflective of that and in keeping with their

fiduciary obligations.

E. USD-INR hurdle rates

In a unified structure, the Indian AIF may either offer

(i) an INR hurdle rate to all its investors, whether

Indian or foreign; or (ii) an INR hurdle rate to Indian

investors and a USD hurdle rate to foreign investors.

Commitments by the Indian investors and the

offshore fund to the Indian AIF will be denominated

and drawn down in Indian Rupees and commitments

by the offshore investors to the offshore fund will be

denominated and drawn down n US Dollars. This

exposes the corpus of the Indian fund to exchange

rate fluctuations which impacts the ratio of unfunded

capital commitments among Indian investors and

offshore investors.

There are a variety of options available to deal with

the exchange rate fluctuations in a unified structure,

depending on the commercial expectations. The

exchange rate ratio may either be fixed from the date

of the first closing itself, or may be closed at the time

of final closing, as no further commitments will be

expected after the final closing into the Indian AIF.

If there are certain unfunded commitments

remaining at either the offshore fund level or the

Indian AIF level due to currency fluctuations while

the other vehicle’s unfunded capital commitments

have reduced to nil (in case the GP is unable to align

the ratio of drawdown between the two pools of

investors with the exchange rate fluctuation), then

the commitment period of the relevant vehicle

may be terminated at the discretion of the manager

/ advisor (as applicable). Alternatively, with the

approval of the requisite investors, such remaining

capital commitments may also be utilized.

F. Co-investment Opportunities

In a unified structure, offering of co-investment

rights to LPs of the offshore fund needs to be designed

carefully to allow efficient implementation.

G. Key person events

Existing India funds are seen grappling with key

person clauses given the reshuffling of investment

management personnel (including spinoffs and

formation of new ventures). Many large PE fund

managers of India focused funds have recently seen

senior level officials quit to start their own ventures.

GPs are exploring ways of identification of key

persons and related (proportionate) consequences,

as LPs look to be as inclusive as possible while

determining time commitment of key persons. While

the CXO level personnel continue to be relevant,

LPs also expect the GP team to take a haircut on

its economics if it is unable to retain talent at the

investment management team level. Concepts

of ‘super key person’ and ‘standard key person’ are

increasingly becoming common.

Consequences of key person events are not expected to

be limited to suspension of investment period anymore,

but if uncured, may also trigger consequences that are at

par with removal for cause events.

H. Side-letter items

Typically, investors may seek differential arrangements

with respect to co-investment allocation, membership

to LPACs, excuse rights, specific reporting formats,

prohibited investment sectors etc. An investor may also

insist on including a ‘most favored nation’ (or MFN)

clause to prevent any other investor being placed in a

better position than itself.

It is relevant for all investors that the Indian AIF is

able to effect the terms entered into by investors

whether directly at the Indian AIF level or the

offshore fund, including making available rights

under MFN provisions.




33

In the template PPM, SEBI has prescribed that

investors be informed of any side letters that have

been entered into by the Fund.

I. Closing Adjustments

A common fund term in all private equity funds

requires closing adjustments to be made when a

new investor is admitted to the fund at any closing

subsequent to the first closing.

In a unified structure, a new investor in the offshore

fund would be required to compensate the existing

investors at the offshore fund level as well as the Indian

AIF level and vice-versa for a new investor participating

subsequent to the first closing in the Indian AIF

J. Excuse Rights

Domestic insurers continue to remain a significant

source of asset allocation. Indian insurers regulated

by the Insurance Regulatory and Development

Authority of India are required to ensure that their

capital contributions are not invested outside

India. Likewise, other statutory / state-aided Indian

institutional investors impose similar conditions

while making commitment to a fund. Investment

programs for several DFIs too require that they be

excused from certain deals if the fund were to explore

certain opportunities. However, the terms on which

an investor maybe excused shall be disclosed upfront

in the relevant agreements.

K. Removal of GPs

‘For cause’ removal typically refers to the premature

termination of the manager’s services to the fund by

the LPs, owing to events of default – mainly fraud,

willful misconduct, and gross negligence.

The relevant question in the context of some of the

recent funds has been on who determines whether a

‘Cause’ event has occurred. Global LPs are circumspect

about the determination standard to be Indian courts,

because of the perception that dispute resolution by

way of litigation in India may take unreasonably long

to conclude.



34

6. Fund Documentation

Fund counsels are now required to devise innovative

structures and advise investors on terms for meeting

investor’s (LP) expectations on commercials,

governance and maintaining discipline on the

articulated investment strategy of the fund. All

these are to be done in conformity with the

changing legal framework.

To attract high quality LPs, it is essential that the

fund documents (including the investor pitch and

the private placement memorandum) include an

articulation on the fund’s governance standard. It

is also essential that global best practices are taken

into account when preparing such fund documents

including contribution agreements, LP side letters

and closing opinion, and to ensure that the same are

not just confined to Indian regulatory and tax aspects.

Enforceability of provisions contained in the fund

documents, and their inter-se applicability on investors

and fund parties is of utmost importance while

designing fund documents. Investors expect their side

letters to prevail with respect to them over the other

fund documents, whereas, for collective claims by all

investors, the charter documents should prevail.

Fund documents are an important aspect of the

fundraising exercise. They are also critical to

determine whether a pooling vehicle is in compliance

with the applicable law across various jurisdictions.

For an India-focused fund or a fund with India

allocation which envisages LP participation both

at the offshore level and at the Indian level, the

following documents are typically prepared:

I. At The Offshore Fund Level

A. Private Placement Memorandum / Wrapper

The private placement memorandum (“PPM”) is a

document through which the interests of the fund are

marketed to potential investors. Accordingly, the PPM

outlines the investment thesis of a fund, summarizes

the key terms on which investors could participate

in the fund’s offering and also presents the potential

risk factors and conflicts of interest that could arise to

an investor considering an investment in the fund. A

wrapper is a short supplement that is attached to the

PPM of a domestic fund (in case of ‘unified structure’)

to help achieve compliance with the requirements

for private placement of the securities / interests of

an offshore fund to investors in jurisdictions outside

India. The use of a wrapper is common in the case

of unified investment structures as the risks of the

onshore fund are inherent in the shares / LP interests

issued to investors to the offshore fund.

B. Constitution

A constitution is the charter document of an offshore

fund in certain jurisdictions. It is a binding contract

between the company (i.e. the Fund), the directors of

the company and the shareholders (i.e. the investors)

of the company.

C. Subscription Agreement

The subscription agreement is an agreement that

records the terms on which an investor will subscribe

to the securities / interests issued by an offshore fund.

The subscription agreement sets out the investor’s

capital commitment to the fund and also records

the representations and warranties made by the

investor to the fund. This includes the representation

that the investor is qualified under law to make the

investment in the fund.35

D. Advisory Agreement

The board of an Offshore Fund may delegate its

investment management / advisory responsibilities

to a separate entity known as the Investment Advisor

or the Investment Manager. The Investment Advisory

35. In case the fund is set up in the format of a limited partnership, this document would be in the format of a limited partnership agree-ment (with the ‘general partner’ holding the management interests).




35

Agreement contains the general terms under which

such investment advisor renders advise in respect of

the transactions for the Fund’s board.

Sometimes, the investment advisor / manager of an

offshore fund enters into a ‘sub-advisory agreement’

with an on-the-ground investment advisory entity

(the sub-advisor). The sub- advisory agreement

typically provides that the sub-advisor will provide

non-binding investment advice to the investment

advisor of the offshore fund for remuneration.

II. At The Onshore Fund Level

A. Private Placement Memorandum

AIF Regulations require that a concerned fund’s

PPM should contain all material information about

the AIF, including details of the manager, the

key investment team, targeted investors, fees and

other expenses proposed to be charged from the

fund, tenure of the scheme, conditions or limits on

redemption, investment strategy, risk factors and

risk management tools, conflicts of interest and

procedures to identify and address them, disciplinary

history, terms and conditions on which the manager

offers services, affiliations with other intermediaries,

manner of winding up the scheme or the AIF and

such other information as may be necessary for an

investor to make an informed decision as to whether

to invest in the scheme of an AIF.36

SEBI has now directed fund managers to add by way

of an annexure to the placement memorandum,

a detailed tabular example of how the fees and

charges shall be applicable to the investor and the

distribution waterfall for AIFs.37

AIFs should also include disciplinary actions in its

PPM.38 It has been clarified by SEBI that AIFs should

also include a disciplinary history of the AIF, sponsor,

36. Regulation 11 of the AIF Regulations, 2012.

37. Paragraph 2(a)(i)of the SEBI Circular CIR/IMD/DF/14/2014.

38. Regulation 11(2) AIF Regulations.

manager and their directors, partners, promoters and

associates and a disciplinary history of the trustees or

the trustee company and its directors if the applicant

for AIF registration is a trust.39

Any changes made to the PPM submitted to SEBI at the

time of the application for registration as an AIF must

be listed clearly in the covering letter submitted to SEBI

and further to that, such changes must be highlighted

in the copy of the final PPM.40 In case the change to the

PPM is a case of a ‘material change’ (factors that SEBI

believes to be a change significantly influencing the

decision of the investor to continue to be invested in the

AIF), said to arise in the event of (1) change in sponsor

/ manager, (2) change in control of sponsor / manager,

(3) change in fee structure or hurdle rate which may

result in higher fees being charged to the unit holders),

existing unit holders who do not wish to continue post

the change shall be provided with an exit option.41

This change is critical for fund managers to note. Such

disclosure reduces the space for ‘views’ being taken

by a fund manager in a given liquidity event leading

to distribution. This also requires that the fund

manager engages more closely with the fund counsel

to articulate the waterfall in a manner that they can

actually implement with a degree of automation.

Any deviance from the waterfall as illustrated in the

fund documents could potentially be taken up against

the fund manager.

While global investors prefer excluding the PPM from

being an ‘applicable fund document’ to investors,

SEBI expects the manager to ensure that each of the

investors has read and agreed to the terms in the PPM.

Also, as explained above, SEBI primarily reviews the

PPM to grant registration as an AIF to the applicants.

This often becomes a matter of concern during LP-GP

negotiations. Unless a waiver has been taken, the

AIF shall abide by the template form of the PPMs as

discussed in detail in the previous section.

39. Paragraph 2(a)(ii) of the SEBI Circular CIR/IMD/ DF/14/2014Regulation.

40. Paragraph 2(b)(i) of the SEBI Circular CIR/IMD/DF/14/2014.

41. Paragraph 2(b)(iv)(a) of the SEBI Circular CIR/IMD/DF/14/2014.



36

B. Indenture of Trust

The Indenture of Trust is an instrument that is

executed between a settlor and a trustee whereby the

settlor conveys an initial settlement to the trustee

towards creating the assets of the fund. The Indenture

of Trust also specifies the various functions and

responsibilities to be discharged by the appointed

trustee. It is an important instrument from an

Indian income - tax perspective since the formula for

computing beneficial interest is specified.

The formula for computing beneficial interest is

required to establish the determinate nature of the

trust and consequently for the trust to be treated

as a pass-through entity for tax purposes.

C. Investment Management Agreement

The Investment Management Agreement is to be

entered into by and between the trustee and the

investment manager (as the same may be amended,

modified, supplemented or restated from time to

time). Under this Agreement, the trustee appoints

the investment manager and delegates all its

management powers in respect of the fund (except

for certain retained powers that are identified in the

Indenture of Trust) to the investment manager.

D. Contribution Agreement

The Contribution Agreement is to be entered into

by and between each contributor (i.e. investor), the

trustee and the investment manager (as the same

may be amended, modified, supplemented or restated

from time to time) and, as the context requires. The

Contribution Agreement records the terms on which

an investor participates in a fund. This includes

aspects relating to computation of beneficial interest,

distribution mechanism, list of expenses to be borne by

the fund, powers of the investment committee, etc. A

careful structuring of this document is required so that

the manager / trustee retain the power to make such

amendments to the agreement as would not amend the

commercial understandings with the contributor.

SEBI also requires that the terms of the Contribution

Agreement should be in alignment with the terms of

the PPM and should not go beyond the same.

III. Investor Side Letters

It is not uncommon for some investors to ask

for specific arrangements with respect to their

participation in the fund. These arrangements are

recorded in a separate document known as the

side letter that is executed by a specific investor,

the fund and the investment manager. Typically,

investors seek differential arrangements with

respect to management fee, distribution mechanics,

participation in investment committees, investor

giveback, etc. An investor may also insist on

including a ‘most favoured nation’ (“MFN”) clause

to prevent any other investor being placed in a better

position than itself. An issue to be considered is

the enforceability of such side letters unless it is an

amendment to the main contribution agreement itself.

SEBI has now, through its Circular on Disclosure

Requirements, made it mandatory for the PPMs to

provide for various disclosures. Some of them include

disclosure of whether any side letters shall be offered,

the criteria for offering differential rights (quantitative/

qualitative/both), list of commercial / non-commercial

terms on which differential rights may be / may not

be offered. SEBI also mandated for the PPM to include

a declaration to the effect that the terms of the side

letters shall not alter the rights of other investors.

IV. Agreements with Service Providers

Sometimes, investment managers may enter into

agreements with placement agents, distributors and

other service providers with a view to efficiently

marketing the interests of the fund. These services

are offered for a consideration which may be linked

to the commitments attributable to the efforts of the

placement agent / distributor.




37

V. Applicability of Stamp Duty

The amendments to the Indian Stamp Act, 1899

(w.e.f. from July 01, 2020) have made provision for

the payment of stamp duty on issuance and transfer

of securities (other than debentures). The definition

of ‘securities’ to be perused for this provision has to be

borrowed from the Securities Contracts (Regulation)

Act, 1956 (“SCRA”) and will also include any other

instrument as declared by the Central Government.

While prior to the introduction of this provision, the

AIF units were not considered ‘securities’ as per the

SCRA, the SEBI recently issued a Circular42 to this

effect thus bringing the AIF units within the purview

of the said amendment. Furthermore, the Department

of Economic Affairs also released a set of FAQs to

clarify this aspect.

42. https://www.sebi.gov.in/legal/circulars/jun-2020/collection-of-stamp-duty-on-issue-transfer-and-sale-of-units-of-aifs_46983.html.

Hence, as per the amendment, issuance of AIF units

will now attract a stamp duty of 0.005% of the value

of units excluding charges such as management fee,

GST etc. Transfer of units on delivery basis will attract

a stamp duty of 0.015% whereas transfer on a non-

delivery basis will attract a stamp duty of 0.003% on

the transfer consideration. It is noteworthy that the

redemption of units shall not require payment of stamp

duty. The FAQs have clarified that the stamp duty

will be collected by Registrar to an issue/share transfer

agent (“RTA”) and in demat form will be collected by a

depository in terms of Section 9A of the Stamp Act.

https://www.sebi.gov.in/legal/circulars/jun-2020/collection-of-stamp-duty-on-issue-transfer-and-sale-of-units-of-aifs_46983.html.

https://www.sebi.gov.in/legal/circulars/jun-2020/collection-of-stamp-duty-on-issue-transfer-and-sale-of-units-of-aifs_46983.html.



38

7. Hedge Funds

‘Hedge funds’ lack a precise definition. The term

has been derived from the investment and risk

management strategies they tend to adopt.

The Indian regulators’ comfort in allowing access

to global hedge funds is of recent origin. It was only

gradually that several investment opportunities

were opened for investors participating under the FII

Regulations that allowed for a wider gamut of strategy

implementation for a hedge fund.

The FPI Regulations 2014 were superseded by the

FPI Regulations, 2019, which implemented several

recommendations of the expert committee that had

been set up by SEBI for revamping the FPI regime,

chaired by former deputy governor of the RBI, HR

Khan. This section deals with eligible participants

under the FPI Regulations, 2019, the range of

investment and hedge strategies that may be adopted

and the scope of dealing with contract notes (swaps

and offshore derivative instruments, i.e. ODIs).

On the onshore side, SEBI allows hedge strategies as a

possible investment strategy that a ‘Category III’ AIF

could adopt. This section also deals with the basic

framework within which such onshore ‘hedge’ funds

are allowed to operate.

I. FPI Regulations

A. Meaning of FPI

The term ‘FPI’ means a person registered as such

under Chapter II of the FPI Regulations 2019. No

person is permitted to transact in securities as a FPI

unless it has obtained a registration certificate granted

by a custodian registered as a Designated Depositary

Participant (“DDP”) under the FPI Regulations 2019.

An offshore fund floated by an asset management

company that has received no-objection certificate

in accordance with the Mutual Fund Regulations,

shall be required to obtain registration as a FPI for

investment in securities in India, till the expiry of the

block of three years.

In respect of entities seeking to be registered as FPIs,

DDPs are authorized to grant registration on behalf of

SEBI, under the FPI Regulations.

The application for grant of registration is to be made

to the DDP in a prescribed form along with the

specified fees. The eligibility criteria for an FPI, inter-

alia, include:

i. The applicant is a person not resident in India;43

ii. The applicant is not a non-resident Indian or an

overseas citizen of India;

iii. The applicant is resident of a country whose

securities market regulator is a signatory to

the International Organization of Securities

Commission’s Multilateral Memorandum

of Understanding or a signatory to a bilateral

Memorandum of Understanding with the SEBI;

provided that an applicant being Government or

Government related investor shall be considered

as eligible for registration, if such applicant is a

resident in the country as may be approved by the

Government of India;

iv. the applicant is a fit and proper person based on

the criteria specified in Schedule II of the Securities

and Exchange Board of India (Intermediaries)

Regulations, 2008.

Appropriate exemptions from the above criteria are

extended to FPIs set up in an IFSC.

A certificate of registration granted by a DDP shall be

permanent, subject to payment or recurring license

fees for blocks of three years, unless suspended or

cancelled by SEBI or surrendered by the FPI.

B. Categories of FPI

The FPI Regulations classify FPIs into two categories

based on their perceived risk profile. An outline of the

two categories is provided below:

43. The term “persons”, “non-residents” and “resident” used herein have the same meaning as accorded to them under the ITA.




39

Category I Category II

i. Government and Government related investors such as central banks, sovereign wealth funds, international or multilateral organizations or agencies including entities controlled or at least 75% directly or indirectly owned by such Government and Government related investor(s);

ii. Pension funds and university funds;

iii. Appropriately regulated entities such as insurance or reinsurance entities, banks, asset management companies, investment managers, investment advisors, portfolio managers, broker dealers and swap dealers;

iv. Entities from FATF member countries, or from any country specified by the Central Government by an order or by way of an agreement or treaty with other sovereign Governments, which are (A) appropriately regulated funds; (B) unregulated funds whose investment manager (IM) is appropriately regulated and registered as a Category I FPI: provided that the IM undertakes the responsibility of all the acts of commission or omission of such unregulated fund; and (C) university related endowments of such universities that have been in existence for more than five years;

v. An entity (A) whose IM is from the FATF country and such an IM is registered as a Category I FPI; or (B) which is atleast 75% owned, directly or indirectly by another entity, eligible under sub-clause (ii), (iii) and (iv) of clause (a) of this regulation and such an eligible entity is from a FATF member country:

Provided that such IM or eligible entity undertakes the responsibility for all the acts of commission or omission of the FPI seeking registration under this provision.

i. appropriately regulated funds not eligible asfor Category -I foreign portfolio investorFPI registration;

ii. endowments and foundations;

iii. charitable organisations;

iv. corporate bodies;

v. family offices;

vi. Individuals;

vii. appropriately regulated entities investing on behalf of their client, as per conditions specified by the Board from time to time;SEBI; and

viii. Unregulated funds in the form of limited partnership and trusts;.

An “appropriately regulated” entity means an entity

which is regulated by the securities market regulator

or the banking regulator of home jurisdiction or

otherwise, in the same capacity in which it proposes

to make investments in India.44

An applicant incorporated or established in an IFSC is

deemed to be appropriately regulated.45

C. FATF compliance

The FPI Regulations 2019 places an increased focus on

classification of countries or jurisdictions by the FATF

when prescribing eligibility criteria for registration as

a FPI, both generally and specifically for eligibility as a

Category I FPI.

Recently Mauritius was added to the FATF ‘grey list’.

This led to significant confusion and speculation as to

the status of Mauritius-based FPIs, in light of certain

provisions in the Operational Guidelines, which

restrict investment by FPIs based out of jurisdictions

44. Regulation 2 (1)(b) of the FPI Regulations.

45. Explanation to Regulation 5.

identified by the FATF as “high risk” and “non-

cooperative” jurisdictions.

SEBI issued a press release on February 25, 2020,

providing clarity and assurance that “FPIs from

Mauritius continue to be eligible for FPI registration

with increased monitoring as per FATF norms”,

putting these concerns at bay. The guidance from

FATF to its members (which includes India) in such

cases is to take this into account in their risk analysis;

accordingly, the view taken by SEBI to not restrict

participation by Mauritius-based FPIs and new

applicants but, subject them to enhanced monitoring,

is pragmatic.

Further to the same, SEBI introduced an amendment

in the FPI Regulations 2019, pursuant to which the

Indian government may notify FPIs from countries

that are not member countries of the FATF as eligible

to register in category I FPIs. Soon thereafter, the

Ministry of Finance, GoI, by way of an order dated

April 13, 2020,46 specified Mauritius as an eligible

46. https://nsdl.co.in/downloadables/pdf/2020-0008-Policy-DDP-Ministry%20of%20Finance%20order%20dated%20April%2013,%202020.pdf.

https://nsdl.co.in/downloadables/pdf/2020-0008-Policy-DDP-Ministry%20of%20Finance%20order%20dated%20April%2013,%202020.pdf.





40

country, allowing Mauritius-based FPIs to register as

Category I FPIs, thus eliminating the ambiguity.

D. Broad Based Criteria

Under the erstwhile FII Regulations, a “broad- based

fund” meant a fund, established or incorporated outside

India which has at least 20 investors with no individual

investor holding more than 49% of the shares or units

of the fund. Further, any institutional investor holding

more than 49% of the shares or units of the fund would

have to itself satisfy the broad based criteria.47

While under the FPI Regulations, 2014, every fund,

and also every sub-fund or share class (in case of

segregated portfolios) needed to separately fulfil the

broad based criteria, the FPI Regulations 2019 has

completely done away with this criteria, which is a

welcome move from the perspective of many FPIs.

E. Investments under FPI Regulations 2019

Under the FPI Regulations 2019, FPIs are permitted to

invest in the following:

a. shares, debentures and warrants issued by

a body corporate; listed or to be listed on a

recognized stock exchange in India,

b. units of schemes floated by mutual funds under

Chapter V, VI-A, and VI-B of the Mutual Fund

Regulations, 1996;

c. units of scheme floated by a Collective Investment

Scheme in accordance with CIS Regulations, 1999;

d. derivatives traded on a recognized stock

exchange;

e. units of REITs, InvITs and units of Category III

AIFs registered with the Board;

f. Indian depository receipts;

g. any debt securities or other instruments as

permitted by the RBI for FPIs to invest in from

time to time; and

47. Explanation 2 to Regulation 5.

h. Any such other instruments specified by SEBI

from time to time.

In respect of investments in the secondary market,

an FPI shall transact in the securities in India only on

the basis of taking and giving delivery of securities

purchased or sold except in the following cases:48

a. any transactions in derivatives on a recognized

stock exchange;

b. short selling transactions in accordance with

the framework specified by SEBI;

c. any transaction in securities pursuant to an

agreement entered into with the merchant

banker in the process of market making or

subscribing to unsubscribed portion of the issue

in accordance with Chapter IX of the Securities

and Exchange Board of India (Issue of Capital

and Disclosure Requirements) Regulations, 2018;

d. any other transaction specified by SEBI.

Furthermore, with regards to secondary markets,

transactions involving dealing in securities by a FPI

shall only be through stock brokers registered with

the Board except in certain limited cases.

No single FPI or investor group (any group of FPIs

having common ownership of at least 50% or

common control) is permitted to hold 10% or more of

equity instruments of a single company.

Further, total equity holding of all FPIs whether or not

of the same group may not exceed 24% of equity of

a company, with the company having an option to

increase this limit to the sectoral cap through a board and

general body resolution.49 From April 01, 2020 onwards,

the default aggregate limit would be the sectoral cap.

In the event investment in a company by an FPI

results in a breach of either the individual or

aggregate limits, such FPI would have a window

period of five trading days from the day of settlement

of trades causing the breach to divest its holdings in

such company to a level below the concerned limit.50

48. Regulation 20(4) of the FPI Regulations.

49. Para 1(a)(i) of Schedule II of NDI Rules.

50. Para 1(a)(iii) of Schedule II of NDI Rules.




41

F. FPIs in International (IFSC) Financial Services Centre

SEBI registered FPIs, proposing to operate in IFSC,

shall be permitted to do so without undergoing any

additional documentation and/or prior approval

process. In case of participation of FPI in IFSC, due

diligence carried out by the DDP at the time of

account opening & registration would be considered.

FPIs, who presently operate in Indian securities

market and propose to operate in IFSC also, shall be

required to ensure clear segregation of funds and

securities. The FPI Regulations 2019 have extended

certain leeway to entities established in IFSC, in terms

of the eligibility norms required to be fulfilled by FPIs

for registration with SEBI.

G. Ownership and Management Restrictions

In addition to the various eligibility criteria laid down

under the FPI Regulations 2019, the Operational

Guidelines prescribe conditions for participation by

NRIs / OCIs / RIs in an FPI and management of an FPI

by NRIs / OCIs / RIs.

a. NRI / OCI / RI constituents: Participation by

a single NRI / OCI / RI should be restricted to

25% and participate by NRIs / OCIs / RIs in

aggregate should be restricted to below 50% of

the corpus of the FPI. SEBI has clarified that the

contribution of RIs is permitted if made through

the LRS in global funds that have an India

exposure of less than 50%.

b. NRI / OCI / RI management and control of

FPIs: NRIs / OCIs / RIs should not be in control

of FPIs. This condition is not applicable to an

‘offshore fund’ in respect of which a no-objection

certificate has been issued by SEBI in terms of

the Mutual Fund Regulations, or, is controlled

by an IM which is owned and controlled by

NRIs / OCIs / RIs, provided that (i) the IM is

appropriately regulated in its home jurisdiction

and registers itself with SEBI as a non-investing

FPI; or (ii) the IM is incorporated or set up in

India and appropriately registered with SEBI.

SEBI has clarified that a non-investing FPI may

be owned and / or controlled by a NRI / OCI / RI.

H. Tax Treatment of FPI Investments

The tax treatment of FPIs registered under the FPI

Regulations would be similar to the treatment accorded

to FIIs. Accordingly, all such FPIs would be deemed to

be Foreign Institutional Investors under Explanation (a)

to section 115AD and would be taxed similarly.

The ITA with effect from April, 2015 states that

securities held by an FPI will be considered “capital

assets”, and gains derived from their transfer will be

considered “capital gains”.

As a result of this amendment, gains arising on

disposal / transfer of a range of listed securities

including shares, debentures and eligible derivative

instruments as may have been acquired under

applicable laws, shall be taxed as capital gains (and

not business income) under Indian domestic law.

The characterization has been a long standing point

of contention under Indian tax law. This is because,

under Indian tax treaties, the business income of a

non-resident is not taxable in India unless the non-

resident has a permanent establishment in India.

In comparison, capital gains are generally taxable

unless the non-resident invests through a favorable

DTAA jurisdiction such as Netherlands or France.

While revenue authorities have tended to treat the

income of FPI as capital gains on this account, the

position has undergone much litigation in the past.

As per the amendment made by the Finance Act,

2020, indirect transfer provisions shall not apply to

non-resident investors of SEBI registered Category I

Foreign Portfolio Investors under the FPI Regulations

2019. A grandfathering has been provided to the non-

resident investors holding an asset in the erstwhile

Category-I and Category-II FPIs up to the date of

repeal of the FPI Regulations 2014.



42

II. Participatory Notes and Derivative Instruments

A. Overview

P-Notes are a form of Offshore Derivative Instruments

(“ODIs”). Under the FPI Regulations 2019, an ODI

is defined to mean any instrument, by whatever

name called, which is issued overseas by an FPI

against securities held by it in India, as its underlying.

FPIs can issue, subscribe to or otherwise deal in

ODIs, directly or indirectly, provided the following

conditions are satisfied:

§ Such ODIs are issued only by persons registered as

Category I FPI;

§ Such ODIs are issued only to persons eligible for

registration as Category I FPI;

§ Such issuance should be in compliance with the

‘know your client’ norms;

§ The FPI must ensure that any transfer of any ODIs

issued by or on behalf of it is permissible as per

the abovementioned points in this list, and the

transfer must be with prior consent of the FPI or

alternatively, be pre-approved by the FPI;

§ The FPI must fully disclose to SEBI, any

information concerning the terms of and parties

to the ODIs issued at the back of any Indian

securities listed or proposed to be listed on a stock

exchange in India, as and when such information

is called for by SEBI; and

§ The FPI must collect the applicable regulatory fee,

from every subscriber of the ODI issued by it and

deposit the same with SEBI.

B. Position of Tax on P-Notes

Under sections 4 and 5 of the ITA, non- residents

may be taxed only on income that accrues in India or

which arises from sources in India. The source rules

for specific types of income are contained in section

9, which specifies certain circumstances where such

income is deemed to accrue or arise in India.

Capital gains from the transfer or sale of shares or

other securities of an Indian company held as capital

assets would ordinarily be subject to tax in India

(unless specifically exempted).

Under section 9(1)(i) of the ITA, income earned by a

non-resident from the transfer of a capital asset situated

in India would be deemed to have been accrued in

India (i.e. be sourced in India). Therefore, a non-resident

may be liable to tax in India if it earns income from the

transfer of a capital asset situated in India.

In Vodafone International Holdings B.V. v. Union of

India,51 the Indian Supreme Court stated that the

Indian tax authorities are to only “look at” a particular

document or transaction when determining the

taxability thereof, thus, indicating a form-over-

substance approach with respect to taxation. Thus,

in light of the abovementioned determination, an

indirect transfer of capital assets situated in India,

between two non-residents, executed outside India

was held to be not taxable under the ITA.

In response to the decision of the Supreme Court,

a retroactive clarification was inserted in the ITA

by the Finance Act, 2012, to state that such foreign

shares or interest may be treated as a capital asset

situated in India if it “derives, directly or indirectly,

its value substantially from assets located in India”.

Explanation 5 to section 9(1) (i) expands the source

rule to cover shares or interest in a foreign company,

the value of which is substantially derived from assets

situated in India.

However, while the foreign shares / interest may be

deemed to be situated in India, the charge of capital

gains tax may not extend to that portion of its

value relating to assets located outside India. Assets

located outside India do not have any nexus with the

territory of India to justify taxation under the ITA. It

is, therefore, necessary to “read down” the amended

section 9(1)(i) based on the nexus principle.

In case of an ODI holder, while the value of the

ODI can be linked to the value of an asset located

in India (equity, index or other forms of underlying

securities from which the swap derives its value), it

51. Vodafone International Holdings B.V. v. Union of India & Anr. [S.L.P. (C) No. 26529 of 2010, dated 20 January 2012].




43

is a contractual arrangement that does not typically

obligate the ODI issuer to acquire or dispose the

referenced security.

The Protocol amending the India-Mauritius DTAA

may have an adverse effect on ODI issuers that

are based out of Mauritius. While most of the

issuers have arrangements to pass off the tax cost

to their subscribers, the arrangement may have

complications due to a timing mismatch as the issuer

could be subject to tax on a first-in-first out (“FIFO”)

basis (as opposed to a one-to-one co-relation).

III. Onshore Hedge Funds

As has been previously discussed, SEBI introduced

different categories of AIFs to cater to different

investment strategies. Category III AIFs is a fund

which employs diverse or complex trading strategies

and may involve leverage including through

investments in listed or unlisted derivatives.

While the general characteristics of Category III AIFs

have been discussed previously, it is important to

stress on certain key aspects. The AIF Regulations

provide that Category III AIFs may engage in leverage

or borrow subject to consent from the investors in

the fund and subject to a maximum limit specified

by SEBI. On July 29, 2013, SEBI issued a circular

which lays down certain important rules relating to

redemption restrictions and leverage.

A. Suspension of Redemptions

A Category III AIF cannot suspend redemptions unless

the possibility of suspension of redemptions has been

disclosed in the placement memorandum and such

suspension can be justified as being under exceptional

circumstances and in the best interest of investors or

is required under AIF Regulation or required by SEBI.

Further, in the event of a suspension of redemption, a

fund manager cannot accept new subscriptions and

will have to meet the following additional obligations:

a. Document reasons for suspension of

redemption and communicate the same to SEBI

and to the investors;

b. Build operational capability to suspend

redemptions in an orderly and efficient manner;

c. Keep investors informed about actions taken

throughout the period of suspension;

d. Regularly review the suspension and take

necessary steps to resume normal operations; and

e. Communicate the decision to resume normal

operations to SEBI.

B. Leverage Guidelines

SEBI limits the leverage that can be employed by any

scheme of a fund to two times (2x) the net asset value

(“NAV”) of the fund. The leverage of a given scheme is

calculated as the ratio of total exposure of the scheme

to the prevailing NAV of the fund. While calculating

leverage, the following points should be kept in mind:

a. Total exposure will be calculated as the sum of

the market value of the long and short positions

of all securities / contracts held by the fund;

b. Idle cash and cash equivalents are excluded

while calculating total exposure;

c. Further, temporary borrowing arrangements

which relate to and are fully covered by capital

commitments from investors are excluded from

the calculation of leverage;

d. Offsetting of positions shall be allowed for

calculation of leverage in accordance with

the SEBI norms for hedging and portfolio

rebalancing; and

e. NAV shall be the sum of value of all securities

adjusted for mark to market gains / losses

including cash and cash equivalents but

excluding any borrowings made by the fund.

The AIF Regulations require all Category III AIFs to

appoint a custodian. In the event of a breach of the

leverage limit at any time, fund managers will have

to disclose such breach to the custodian who in turn

is expected to report the breach to SEBI before 10 AM,

IST (India Standard Time) on the next working day.

The fund manager is also required to communicate

the breach of the leverage limit to investors of the



44

fund before 10 AM, IST on the next working day and

square off the excess exposure to rebalance leverage

within the prescribed limit by the end of the next

working day. When exposure has been squared

off and leverage has been brought back within the

prescribed limit, the fund manager must confirm the

same to the investors whereas the custodian must

communicate a similar confirmation to SEBI




45

8. Fund Governance

A pooled investment vehicle typically seeks to adopt

a robust governance structure. The genesis of this

obligation (other than as may be required under

applicable laws) is in thegenerally accepted fiduciary

responsibilities of managers with respect to the

investor’s money.

In a fund context, the decision making framework

typically follows the following structure –

I. Investment Manager

The investment manager is concerned with all

activities of a fund including its investment and

divestment related decisions. These are typically

subject to overall supervision of the board of directors

of the fund (if set up in the format of a ‘company’).

II. Investment Committee

The Investment Committee (“IC”) scrutinizes all

potential transactions (acquisition as well as exit).

The IC’s role includes maintaining pricing discipline,

ensuring that all transactions adhere to the fund’s

strategy and assessing the risk-return profile of the deals.

The functions of the IC typically include review

of (1) transactions that are proposed by the

investment manager, (2) performance, risk profile

and management of the investment portfolio and

(3) to provide appropriate recommendations to the

investment manager.

Recently in September 2020, SEBI in its board

meeting approved a regulatory amendment to the

AIF Regulations, pursuant to which the constitution

of an IC by the investment manager may be made

mandatory for all AIFs. Other provisions pertaining

to approval of investment decisions by the IC,

responsibilities of the investment manager and the

members of the IC, and so on may also be introduced.

III. Advisory Board

Typically, the Advisory Board’s role is to provide

informed guidance to the investment manager / IC of

the fund based on the information / reports shared by

the investment manager with the Advisory Board.

The Advisory Board typically provide

recommendations to the investment manager / IC

in relation to (1) managing “conflicts of interest”

situations; (2) approval of investments including

co-investment opportunities made beyond the

threshold levels as may have been defined in the fund

documents; (3) approval of reduction of equalization

premium amount; (4) investment manager’s overall

approach to investment risk management and; (5)

corporate governance and compliance related aspects.

IV. Aspects and Fiduciaries to be considered by Fund Directors

The emerging jurisprudence suggests that the

threshold of fiduciaries that is required to be met by

the directors is shifting from “sustained or systematic

failure to exercise oversight” to “making reasonable

and proportionate efforts commensurate with the

situations”. A failure to perform their supervisory

role could raise several issues concerning liabilities of

independent directors for resultant business losses as

would be seen in the case of Weavering Macro Fixed

Income Fund (summarized below).

As a matter of brief background, Weavering Macro

Fixed Income Fund (“Fund”) was a Cayman Islands

based hedge fund. The Fund appointed an investment

manager to ‘manage the affairs of the Fund subject

to the overall supervision of the Directors’. The Fund

went into liquidation at which point in time, action

for damages was initiated by the official liquidators

against the former “independent” directors.



46

The Grand Court of Cayman Islands found evidence

that while board meetings were held in a timely

manner, the meetings largely recorded information

that was also present in the communication to fund

investors and that the directors were performing

‘administrative functions’ in so far as they merely

signed the documents that were placed before them.

Based on such factual matrix, the Grand Court held

against the directors for willful neglect in carrying

out their duties. It was also observed that based on

their inactions, the defendant directors “did nothing

and carried on doing nothing”. The measure of loss

was determined on the difference between the Fund’s

actual financial position with that of the hypothetical

financial position had the relevant duties been

performed by the directors.

The Grand Court ruled against each of the directors

in the amount of $111 million. It was also observed,

that the comfort from indemnity clauses are for

reasonably diligent independent directors to protect

those who make an attempt to perform their duties

but fail, not those who made no serious attempt to

perform their duties at all.

The Grand Court observed that the directors are

bound by a number of common law and fiduciary

duties including those to (1) act in good faith in

the best interests of the fund and (2) to exercise

independent judgment, reasonable care, skill and

diligence when acting in the fund’s interests.

However, the Cayman Islands Court of Appeal

(“CICA”) set-aside the order of Cayman Islands

Grand Court in the case of Weavering Macro Fixed

Income Fund Limited (In Liquidation) vs. Stefan

Peterson and Hans Ekstrom, through its judgment

dated February 12, 2015.

The CICA, while affirming the original findings of

breach of duty by the directors held that there was

no element of ‘wilful’ negligence or default on their

part; therefore, the indemnity provisions in the Fund

documents relieved the directors from liability arising

out of breach of their duties.

The CICA held that the evidence available to the

Grand Court was insufficient to support the finding

that the directors’ conduct amounted to “wilful

neglect or default”. The CICA accordingly set aside

the earlier judgments against each of the directors for

$111 million.

Further, in India, the recent case of RBI & Ors v

Jayantilal N. Mistry & Ors.52 the Supreme Court of

India considered the meaning of the term ‘fiduciary,’

and held that it referred to a person having a duty

to act for the benefit of another (a ‘duty of loyalty’),

showing good faith and candour (‘duty of care’), where

such other person reposes trust and special confidence

in the person owing or discharging the duty. The court

took the view that the term ‘fiduciary relationship’ is

used to describe a situation or transaction wherein one

person (the beneficiary) places complete confidence in

another person (the fiduciary) in regard to his affairs,

business or transaction(s). The term also referred

to a person who held a thing in trust for another

(the beneficiary). The fiduciary is expected to act in

confidence and for the benefit and advantage of the

beneficiary, and to employ good faith and fairness in

dealing with the beneficiary or with things belonging

to the beneficiary. In the aforesaid case, the court

held that “…RBI has no legal duty to maximixe the

benefit of any public sector bank, and thus there is no

relationship of ‘trust’ between them.”53

In a relevant case, HMRC v Holland54 it was observed

that the fact that a person is consulted about

directorial decisions, or asked for approval, does not

in general make him a director because he is not

making the decision.

From a regulatory point of view, Regulation 21

of the AIF Regulations states that, in addition to

the ‘trustee’ (the discharge of whose trusteeship

services constitutes a fiduciary relationship with

the investors), it is the ‘sponsor’ and the ‘investment

manager’ of the AIF that are to act in a fiduciary

capacity toward the investors.

In light of the above, it becomes important to ensure

that the Advisory Board of the Fund is not given any

roles or responsibilities with respect to the Fund

which would subject the members to fiduciary duties.

52. AIR 2016 SC 1.

53. Ibid

54. [2010] 1 WLR 2793.




47

We summarize below the duties of directors (of fund

managers, in case the fund is not self- managed) based

on the above judgments that should guide a director

during the following phases in the life of a fund:

A. At the Fund Formation Stage

Directors must satisfy themselves that the offering

documents comply with applicable laws, that all

conflict of interest situations are addressed upfront,

that the structure of the fund is not only legally

compliant but also ethically permissible, that the

terms of the service providers’ contracts are reasonable

and consistent with industry standards, and that the

overall structure of the fund will ensure a proper

division of responsibility among service providers.

Directors must act in the best interests of the fund

which, in this context, means its future investors.

In this respect, we believe ‘verification notes’ can be

generated. The notes would record the steps which

have been taken to verify the facts, the statements

of opinion and expectation, contained in the fund’s

offering document(s). The notes also serve the

further purpose of protecting the directors who

may incur civil and criminal liability for any untrue

and misleading statements therein or material or

misleading omissions therefrom. Alternatively, a

‘closing opinion’ may also be relied upon.

B. During the Fund’s Tenure

i. Appointment of Service Providers

Directors should consider carefully which service

providers are selected for appointment. They should

understand the nature of the services to be provided

by the service providers to the fund.

ii. Agenda

The formalities of conducting proper board meetings

should be observed. An agenda for such meetings

should list the matters up for discussion, materials

to be inspected, and inputs from the manager, the

service providers and directors themselves. It should

be circulated well in advance.

iii. Actions outside Board Meetings

The directors should review reports and information

that they received from the administrator and

auditors from time to time to independently assess

the functioning of the fund and whether it is in

keeping with the fund’s investment strategy and

compliant with the applicable laws.

iv. Decision Making Process

Directors should exhibit that there was an application

of mind when considering different proposals before

it. The decision making process will also play a pivotal

role in determining the substance of the fund from

an Indian tax perspective as India moves away from

its principle of “form over substance” to “substance

over form” post April 01, 2017. For example, in case

of investor ‘side letters’ that may restrict the fund’s

investments into a restricted asset class, etc., could

raise issues. While execution of such ‘side letters’ may

not be harmful to the fund, but an approval at ‘short

notice’ may be taken up to reflect on the manner in

which the directors perform their duties.

v. Minutes

Board meetings should be followed by accurately

recorded minutes. They should be able to demonstrate

how the decision was arrived at and resolution thereon

passed. The minutes should reflect that the directors

were aware of the issues that were being discussed.

Clearly, a ‘boilerplate’ approach would not work.

vi. Remuneration

The remuneration for independent directors should

be commensurate to the role and functions expected

to be discharged by them. While a more-than-

adequate remuneration does not establish anything,

an inadequate recompense can be taken as a ground

to question whether the concerned director intends to

perform his / her duties to the fund.

vii. Conflict of interest

If related party transactions or transactions that

may raise conflict of interest cannot be avoided,



48

a policy should be outlined where events and

mechanisms to identify and resolve events which

could lead to potential conflicts, should be recorded.

Suitable measures that demonstrate governance and

that the interest of the investors would be unimpaired,

should be adopted.

The rulings discussed confirm that a fund’s board has

duties cast on it and the ‘business judgment rule’ may

ensure that liability is not shielded in all cases.

There are certain non-delegable functions for the

directors to discharge on an on-going basis and none

are more paramount than reviewing of the fund’s

performance, portfolio composition and ensuring

that an effective compliance program is in place.

These functions require action ‘between’ board

meetings and not only ‘during’ board meetings.

The Advisory Board of a fund plays an important

role in resolving conflicts of interest. However, it is

pertinent to note that while the Advisory Board may

take a decision with reference to policies as may be

defined under the fund documents, these decisions

are not binding on the investment manager. While

the Advisory Board may put forward its viewpoints in

terms of the decisions arrived at by it, the Investment

Manager possesses the final decision-making power.




49

9. International Tax Considerations

I. Taxation of Indirect Transfers

In India, residents are taxable on their worldwide

income whereas non-residents are taxable on Indian

source income i.e. income that accrues or arises, or is

deemed to accrue or arise, or is received or is deemed

to be received in India.

As stated above, for a non-resident to be subject to

tax in India, the ITA requires that the income should

be received, accrued, arise or deemed to be received,

accrued or arisen to him in India.55 In this regard,

section 9(1)(i) of the ITA provides the circumstances

under which income of a non- resident may be

deemed to accrue or arise in India:

Section 9(1): “The following income shall be deemed

to accrue or arise in India: (i) all income accruing or

arising, whether directly or indirectly, through or

from any business connection in India, or through

or from any property in India, or through or from

any asset or source of income in India, or through the

transfer of a capital asset situated in India.”

This source rule pertaining to a “capital asset situate

in India” was examined by the Supreme Court of

India in Vodafone International Holdings,5657 which

dealt with transfer of shares of a foreign company

between two non-residents. It was held that a share

is legally situated at the place of incorporation of the

company. Therefore, while the shares of an Indian

company would be considered situated in India, the

shares of a company incorporated outside India

would ordinarily be viewed as situated outside India.

This position has undergone a change pursuant to the

Finance Act, 2012, which amended section 9 of the ITA

through the insertion of Explanation 5 cited below

55. Section 5(2) of the ITA.

56. (2012) 341 ITR 1. “asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be situated in India, if the share or interest derives, directly or indirect-ly, its value from the assets located in India being more than

57. % of the global assets of such company or entity.”

“For the removal of doubts, it is hereby clarified that

an asset or a capital asset being any share or interest

in a company or entity registered or incorporated

outside India shall be deemed to be and shall always

be deemed to have been situated in India, if the share

or interest derives, directly or indirectly, its value

substantially from the assets located in India.”

Therefore, under the current law, shares of a foreign

incorporated company can be considered to be a

“situate in India” if the company derives “its value

substantially from assets located in India.

On the basis of the recommendations provided

by the Shome Committee appointed by the then

Prime Minister, the Finance Act, 2015 had made

various amendments to these provisions which are

summarized below:

A. Threshold test on substantiality and valuation

The ITA, pursuant to amendment by the Finance Act,

2015, provides that the share or interest of a foreign

company or entity shall be deemed to derive its value

substantially from the assets (whether tangible or

intangible) located in India, if on the specified date,

the value of Indian assets (i) exceeds the amount of

INR 100 million; and (ii) represents at least 50% of the

value of all the assets owned by the company or entity.

The value of the assets shall be the Fair Market Value

(“FMV”) of such asset without reduction of liabilities,

if any, in respect of the asset.58

i. Date for determining valuation

Typically, the end of the accounting period preceding

the date of transfer shall be the specified date of

valuation. However, in a situation when the book

value of the assets on the date of transfer exceeds by

at least 15%, the book value of the assets as on the

last balance sheet date preceding the date of transfer,

then the specified date shall be the date of transfer.

58. Explanation 6 to Section 9(1)(i) of the ITA.



50

This results in ambiguity especially in cases where

intangibles are being transferred.

ii. Taxation of gains

The gains arising on transfer of a share or interest

deriving, directly or indirectly, its value substantially

from assets located in India will be taxed on a

proportional basis based on the assets located in India

vis-à-vis global assets.

Exemptions: The ITA, pursuant to amendment by the

Finance Act, 2015, provides for situations when this

provision shall not be applicable. These are:

a. Where the transferor of shares of or interest in a

foreign entity, along with its related parties does

not hold at any time during the twelve months

preceding the date pf transfer (i) the right of

control or management (directly or indirectly);

and (ii) the voting power or share capital or

interest exceeding 5% of the total voting power

or total share capital or total interest in the

foreign company or entity directly holding the

Indian assets (Holding Co).

b. In case the transfer is of shares or interest in a

foreign entity which does not hold the Indian

assets directly, then the exemption shall be

available to the transferor if it along with related

parties does not hold at any time during twelve

months preceding the date of transfer

i. In case the transfer is of shares or interest

in a foreign entity which does not hold the

Indian assets directly, then the exemption

shall be available to the transferor if it along

with related parties does not hold the right

of management or control in relation to such

company or the entity; and

any rights in or in relation to such entity

which would entitle it to either exercise

control or management of the Holding Co.

or entitle it to voting power or total share

capital or total interest exceeding 5% in

the Holding Co. The 5% limit described

above is a far cry from the 26% holding

limit which was recommended by the

Committee. Further, no exemption has

been provided for listed companies, as was

envisaged by the Committee.

In case of business reorganization in the form

of demergers and amalgamation, exemptions

have been provided. The conditions for

availing these exemptions are similar to the

exemptions that are provided under the ITA

to transactions of a similar nature.

iii. Reporting Requirement

The ITA, pursuant to amendment by the Finance Act,

2015, provides for a reporting obligation on the Indian

entity through or in which the Indian assets are held

by the foreign entity.

The Indian entity has been obligated to furnish

information relating to the offshore transaction

which will have the effect of directly or indirectly

modifying the ownership structure or control of the

Indian entity. In case of any failure on the part of

Indian entity to furnish such information, a penalty

ranging from INR 500,000 to 2% of the value of the

transaction can be levied.

In this context, it should be pointed out that it may be

difficult for the Indian entity to furnish information

in case of an indirect change in ownership, especially

in cases of listed companies. Further, there is no

minimum threshold beyond which the reporting

requirement kicks in. This means that even in a case

where one share is transferred, the Indian entity will

need to report such change.

All in all, while these provisions provide some relief

to investors, a number of recommendations as

provided by the Committee have not been considered

by the GoI. Some of these recommendations related to

exemption to listed securities, P-Notes and availability

of DTAA benefits. Further, there are no provisions

for grandfathering of existing investment made in

the past and questions 66. Explanation 6 to Section

9(1)(i) of the ITA arise as to the tax treatment on

transactions undertaken between 2012 and 2015.

As stated above, the Finance Act, 2017 brought

changes to clarify that the indirect transfer tax




51

provisions shall not be applicable to an asset or

capital asset that is held directly/ indirectly by

way of investment in an FII, a Category I FPI or a

Category II FPI. Further, due to the recategorization

of categories of FPIs under the FPI Regulations 2019,

the Budget has exempted the applicability of indirect

transfer tax provisions to Category I FPIs under the

FPI Regulations 2019. This resolves concerns for

a class of offshore funds which are registered as a

category I or category II FPIs (under FPI Regulations

2014)/ Category I FPIs (under FPI Regulations 2019)

as redemptions by investors at the level of the fund

shall not be subject to the indirect transfer taxation.

Further, in multi-tiered structures, if the entity

investing into India is a Category I or Category II FPI

(under FPI Regulations 2014)/ Category I FPIs (under

FPI Regulations 2019), any up-streaming of proceeds

by way of redemption / buyback will not be brought

within the Indian tax net. The provisions also

exclude, from applicability of the indirect transfer

tax provisions, situations where any redemptions

or re-organizations or sales result in capital gains

by investors in Category I or Category II FPIs (under

FPI Regulations 2014)/ Category I FPIs (under FPI

Regulations 2019).

The clarificatory explanations are applicable

retrospectively from FY starting April 1, 2012, and

therefore should help bring about certainty on past

transactions that have been entered into by FII,

Category I and Category II FPI entities.

Through Circular No. 28/201759 CBDT have clarified

that the amendment shall not apply to income arising

or accruing on account of redemption or buyback of

share held by a non-resident in the specified funds, if

it is in consequence of transfer of share or securities

held in India by such fund and if such income is

chargeable in India. The clarification resulted from

concerns raised by investment funds set up as

multitier investment structures, that the income

derived in India on redemption of shares or interest

could be subjected to multiple taxation on every

upper level of the investment structure outside India.

As a result of the circular, non-residents investing in

multi-layered investment structures will be exempted

59. CBDT Circular No. 28 of 2017 dated November 7, 2017

from indirect transfer provisions on account of

redemption of shares or interest outside India.

Thus, adverse effect of amendment has been

minimized by not taxing a non-resident for its capital

gain, in case it made through a specified fund.

II. General Anti-Avoidance Rule (GAAR)

Chapter X-A of the ITA provides for GAAR, which has

come into effect from April 1, 2017. GAAR confers

broad powers on the revenue authorities to deny tax

benefits (including tax benefits applicable under the

DTAA), if the tax benefits arise from arrangements

that are “impermissible avoidance arrangements”.

The introduction of GAAR in the I TA is effective

from financial year 2017-18 and brings a shift

towards a substance based approach. GAAR targets

arrangements whose main purpose is to obtain a

tax benefit and arrangements which are not at arm’s

length, lack commercial substance, are abusive or

are not bona fide. It grants tax authorities powers to

disregard any structure, reallocate / re-characterize

income, deny DTAA relief etc. Further, the ITA

provides that GAAR is not applicable in respect of any

income arising from transfer of investments which

are made before April 1, 2017.

Section 90(2A) of the ITA contains a specific DTAA

override in respect of GAAR and states that the GAAR

shall apply to an assessee with respect to DTAAs, even

if such provisions are not beneficial to the assessee.

The CBDT has issued clarifications on

implementation of GAAR provisions in response

to various queries received from the stakeholders

and industry associations. Some of the important

clarifications issued are as under:

i. Where tax avoidance is sufficiently addressed

by the LOB clause in a tax treaty, GAAR should

not be invoked.



52

ii. GAAR should not be invoked merely on the

ground that the entity is located in a tax efficient

jurisdiction.

iii. GAAR is with respect to an arrangement or part

of the arrangement and limit of INR 30 million

cannot be read in respect of a single taxpayer only.

The Supreme Court ruling in McDowell & Co. Ltd.

CTO60 stated that under the Indian tax laws, even

while predominantly respecting legal form, the

substance of a transaction could not be ignored where

it involved sham or colorable devices to reduce an

entity’s tax liabilities.

Therefore, as per judicial anti-avoidance principles,

the Indian tax authorities have the ability to ignore

the form of the transaction only in very limited

circumstances where it is a sham transaction or a

colourable device.

The GAAR provisions extend the power of the Indian

tax authorities to disregard transactions even when

such transactions / structures are not a “sham” in case

where they amount to an “impermissible avoidance

arrangement”.

An impermissible avoidance arrangement has

been defined as an arrangement entered into with

the main purpose of obtaining a tax benefit. These

provisions empower the tax authorities to declare

any arrangement as an “impermissible avoidance

arrangement” if the arrangement has been entered

into with the principal purpose of obtaining a tax

benefit and involves one of the following elements:

A. Non-arm’s Length Dealings

It refers to arrangements that create rights or

obligations not normally created between independent

parties transacting on an arm’s length basis.

B. Misuse or Abuse of the Provisions of the Act

It results directly or indirectly, in the misuse or abuse

of the ITA.

60. 154 ITR 148.

C. Lack of Commercial Substance

Arrangements that lack commercial substance or are

deemed to lack commercial substance- this would

include round trip financing involving transfer

of funds between parties without any substantial

commercial purpose, self-cancelling transactions,

arrangements which conceal, and the use of an

accommodating party, the only purpose of which is

to obtain a tax benefit. Arrangements are also deemed

to lack commercial substance if the location of assets,

place of transaction or the residence of parties does

not have any substantial commercial purpose.

D. Non-Bona Fide Purpose

Arrangements that are carried out by means or in

a manner which is not ordinarily employed for

a bona fide purpose.

In the event that a transaction / arrangement is

determined as being an ‘impermissible avoidance

arrangement’, the Indian tax authorities would

have the power to disregard entities in a structure,

reallocate income and expenditure between parties

to the arrangement, alter the tax residence of such

entities and the legal situs of assets involved, treat debt

as equity, vice versa, and the like. The tax authorities

may deny tax benefits even if conferred under a DTAA,

in case of an impermissible avoidance arrangement.

Investors have been worried about the scope of the

GAAR provisions and concerns have been raised on

how they would be implemented. A re-look at the

scope of the provisions will definitely be welcomed

by the investment community and it is hoped that

when revised provisions are introduced, they will be

in line with global practices.

III. Business Connection/ Permanent Establishment Exposure

Offshore Funds investing in India have a potential tax

exposure on account of having constituted a permanent




53

establishment in India. In case of determination of a

permanent establishment, the profits of a non-resident

entity are taxable in India only to the extent that

the profits of such enterprise are attributable to the

activities carried out through its PE in India.

What constitutes permanent establishment? Management teams for India focused Offshore

Funds are typically based outside India as an onshore

fund manager enhances the risk of the fund being

perceived as having a PE in India. Although DTAAs

provide for the concept of a permanent establishment

in Article 5 (as derived from the OECD and United

Nations (“UN”) Model Convention), the expression

has not been exhaustively defined anywhere. The

Andhra Pradesh High Court, in CIT v. Visakhapatnam

Port Trust,61 held that:

“The words “permanent establishment” postulate

the existence of a substantial element of an enduring

or permanent nature of a foreign enterprise in

another country which can be attributed to a fixed

place of business in that country. It should be of such

a nature that it would amount to a virtual projection

of the foreign enterprise of one country into the soil

of another country.”

The presence of the manager in India could be

construed as a place of management of the Offshore

Fund and thus the manager could be held to

constitute a permanent establishment. Consequently,

the profits of the Offshore Fund to the extent

attributable to the permanent establishment,

may be subject to additional tax in India.

What tantamounts to business connection in the

context of an Offshore Fund? ‘Business connection’

is the Indian domestic tax law equivalent of the

concept of PE under a DTAA scenario. The term

business connection, however, is much wider. The

term has been provided as an inclusive definition per

Explanation 2 to Section 9(1)(i) of the ITA, whereby

a ‘business connection’ shall be constituted if any

business activity is carried out through a person

who (acting on behalf of the non-resident) has and

habitually exercises in India the authority to conclude

contracts on behalf of the non-resident.

61. 144 ITR 146

Thus, the legislative intent suggests that (in absence

of a DTAA between India and the jurisdiction in

which the Offshore Fund has been set up) under

the business connection rule, an India based fund

manager may be identified as a ‘business connection’

for the concerned Offshore Fund.

It is important to note that the phrase ‘business

connection’ is incapable of exhaustive enumeration,

given that the ITA provides an explanatory meaning

of the term which has been defined inclusively.

A close financial association between a resident

and a non-resident entity may result in a business

connection for the latter in India. The terms of

mandate and the nature of activities of a fund

manager are such that they can be construed as

being connected with the business activity of the

Offshore Fund in India.

Accordingly, Offshore Funds did not typically retain

fund managers based in India where a possibility

existed that the fund manager could be perceived as

a PE or a business connection for the fund in India.

Instead, many fund managers that manage India

focused Offshore Fund, tend to be based outside India

and only have an advisory relationship in India that

provide recommendatory services.

However, the Finance Act, 2015 introduced

amendments to encourage fund management

activities in India – by providing that having an

eligible manager in India should not create a tax

presence (business connection) for the fund in India

or result in the fund being considered a resident in

India under the domestic POEM rule and introducing

section 9A to the ITA.

While Section 9A may be well intentioned, it employs

a number of rigid criteria that would be impossible for

PE funds and difficult for FPIs to satisfy.

Under section 9A of the ITA, if the Fund is falling

within the criteria given in Section 9A (3), then the

said Fund will not be taken as resident in India merely

because the eligible fund manager, undertaking fund

management activities, is situated in India.

The conditions given under Section 9A are as follows:

- (i) the fund must not be a person resident in India;

(ii) the fund must be a resident of a country with



54

which India has entered into an agreement under

Section 90(1) or 90A(1) of the ITA or is established

or incorporated or registered in a country or a

specified territory notified by the GoI in this behalf;

(iii) investment in the fund by persons resident in

India should not exceed 5% of the corpus of the fund;

provided that for the purposes of calculation of the

said aggregate participation or investment in the fund,

any contribution made by the eligible fund manager

during the first three years of operation of the fund,

not exceeding twenty-five crore rupees, shall not be

taken into account (iv) the fund and its activities

are subject to investor protection regulations in the

country in which it is incorporated or resident; (v)

the fund must have minimum twenty five members,

who are not connected persons (vi) any member of

the fund along with connected persons should not

have any participation interest in the fund exceeding

10 % (vii) the aggregate participation interest of ten

or less members along with their connected persons

in the fund, should be less than 50% (viii) the fund

should not invest more than 20%. of its corpus in

any single entity (ix) the fund should not make any

investment in its associate entity; (x) the monthly

average of the corpus of the fund should not be less

than INR 1 billion; provided that if the fund has been

established or incorporated in the previous year, the

corpus of fund shall not be less than INR 1 billion at

the end of a period of twelve months from the last day

of the month of its establishment or incorporation.

Nevertheless, this provision shall not be applicable in

case of the year in which the fund is wound up. (xi)

the fund should not carry on or control and manage,

directly or indirectly, any business in India (xii) the

fund should not engage in any activity which will

constitute business connection in India; (xiii) the

remuneration paid by the fund to the fund manager

should be not less than the arm’s length price. Added to this are certain relaxations provided to the

fund set up by the government or the Central Bank of

a foreign state or a sovereign fund, or any other fund

as notified by the GoI These funds do not have to

comply with the conditions given in clauses (v), (vi)

and (vii) of the above given conditions.

Section 9A also requires an ‘eligible investment

manager’ in respect of an eligible investment fund

to fulfill the following conditions - (a) the person

is not an employee of the eligible investment fund

or a connected person of the fund; (b) the person is

registered as a fund manager or an investment advisor

in accordance with the specified regulations; (c) the

person is acting in the ordinary course of his business

as a fund manager; (d) the person along with his

connected persons shall not be entitled, directly or

indirectly, to more than twenty per cent of the profits

accruing or arising to the eligible investment fund

from the transactions carried out by the fund through

the fund manager. The Finance Act, 2019 amended

one of the conditions for availing safe harbour under

section 9A by removing the requirement for the

eligible fund manager to receive an arm’s length

remuneration for performing the fund management

activity and replacing it with a minimum fee to be

prescribed by the CBDT. On December 5, 2019 CBDT

had released draft notification to amend Rule 10V

of the IT Rules for public comments and inputs

and the amendments have now been notified

through Income Tax (Amendment) Rules, 2020

(“Notification”). The Notification introduces new

rules on remuneration for fund managers to qualify

for safe harbour under section 9A.62

In case where the eligible investment fund is a

registered Category I FPI which has obtained such

registration due to its status as an endowment fund,

a sovereign wealth fund, a Government, a university,

an appropriately regulated entity (banks, insurers,

managers, advisers etc.) under the relevant provisions

as described in the Notification, the amount of

remuneration for the eligible fund manager shall be

at least 0.10% of AUM.

In other cases, (i.e. other than for Category I FPIs of the

kind explained above), the amount of remuneration

for the eligible fund manager is required to be at least:

i. 0.30% of AUM; or

ii. 10% of profits derived by the fund in excess of the

specified hurdle rate, where the fund manager is

entitled only to remuneration linked to the income

or profits derived by the fund; or

62. Notification No G.S.R. 315(E) dated May 27, 2020.




55

iii. 50% of management fee, where the fee is shared

with another fund manager reduced by operational

expenses.

The Notification also allows for the CBDT to approve

a lower remuneration to be charged if the eligible

investment fund is able to satisfy CBDT.

Despite the efforts of the government, onerous

conditions such as the requirement to have

a minimum of twenty-five investors and the

requirement to charge fee that is not less than the

arm’s length price continue to act as roadblocks in the

progress of the provision, as explained in detail below.

Furthermore, regard must also be had to the fact that

Section 9A primarily caters to managers of open-

ended funds. Private equity and venture capital funds

are unlikely to consider using the provision as the

minimum investor requirement, the requirement

to not invest more than 20% of corpus in one entity

and the restriction on “controlling” businesses in

India make it impractical for such funds to consider

using the safe harbour. This is in fact, a mismatch

for the industry as India focused private equity and

venture capital funds have a greater need to have

management personnel based out of India.

A. No ability to “control and manage”

To qualify, the fund shall not carry on or control

and manage, directly and indirectly, any business in

India. It is unclear whether shareholder’s rights such

as affirmative rights can be considered “control and

management”. Further, this exemption will not be

available to buy-out / growth funds, since such funds

typically take a controlling stake and management

rights in the portfolio companies;

B. Broad basing requirement

The eligible fund is required to have a minimum of 25

members who are directly / indirectly unconnected

persons. This seems similar to the broad-basing

criteria which was earlier applied to Category II FPIs

and isn’t quite appropriate for private equity / venture

capital funds which may often have fewer investors.

Further, there is no clarity on whether the test will be

applied on a look through basis (which could impact

master- feeder structures);

C. Restriction on investor commitment

It is required that any member of the fund, along with

connected persons should not have a participation

interest exceeding 10%. It has also been stated that

the aggregate participation of ten or less people

should be less than 50%. This would restrict the

ability of the fund sponsor / anchor investor to

have a greater participation.

It would also have an impact on master feeder

structures or structures where separate sub funds

are set up for ring fencing purposes;

D. Fund manager cannot be an employee

The exemption does not extend to fund managers

who are employees or connected persons of the fund.

Furthermore, it is not customary in industry to engage

managers on a consultancy / independent basis, for

reasons of risk and confidentiality, particularly in a

private equity / venture capital fund context. Therefore,

this requirement is likely to be very rarely met.

The proposed amendments do not leave funds worse

off – however, they are unlikely to provide benefit to

private equity / venture capital funds or FPIs. Firstly,

a fund manager exemption is more relevant in

a private equity / venture capital context, where

on ground management is more of a necessity.

For the reasons discussed above, private equity /

venture capital funds are unlikely to be able to take

advantage of section 9A. If the intent was to provide PE

exclusion benefits to FPIs investing in listed securities,

it would have been more appropriate to clarify the risk

on account of colocation servers in India on which

automated trading platforms are installed. Secondly,

FPI income is characterized as capital gains, and hence,

the permanent establishment exclusion may only be

relevant to a limited extent arrangement.



56

Annexure I

Sector Focused Funds

I. Social Venture Funds

A. Introduction

Even though social venture funds were existent in

practice, it was only under the AIF Regulations that

were formally recognized. Under the AIF Regulations,

a social venture fund is defined as, “an alternative

investment fund which invests primarily in securities

or units of social ventures and which satisfies social

performance norms laid down by the fund and

whose investors may agree to receive restricted or

muted returns.”

Typically, social venture funds tend to be impact

funds which predominantly invest in sustainable and

innovative business models. The investment manager

of such fund is expected to recognise that there is a need

to forecast social value, track and evaluate performance

over time and assess investments made by such funds.

B. Characteristics of Social Venture Funds

Social venture funds tend to be different from venture

capital funds or private equity funds not just in the

investments that they make, but also in the nature

of commitments that they receive from their limited

partners / investors. The following is a list of some

of the characteristics that a social venture fund may

expect to have:

§ Investors making grants (without expectation of

returns) instead of investments;

§ Fund itself providing grants and capital support

considering social impact of such participation as

opposed to returns on investment alone;

§ Fund targeting par returns or below par returns

instead of a fixed double digit IRR;

§ Management team of the fund participating

in mentoring, “incubating” and growing their

portfolio companies, resulting in limited token

investments (similar to a seed funding amount),

with additional capital infused as and when the

portfolio grows;

§ Moderate to long term fund lives in order to

adequately support portfolio companies.

Social venture funds also tend to be aligned towards

environmental, infrastructure and socially relevant

sectors which would have an immediate impact in the

geographies where the portfolio companies operate.

C. Tools to Measure Social Impact

Managers of social impact funds rely on specific

systems to quantify the social value of investments.

Some of these include:

§ Best Alternative Charitable Option (“BACO”),

developed by the Acumen Fund.

§ Impact Reporting & Investment Standards

(“IRIS”), developed by Global Impact Investing

Network (“GIIN”).

§ Global Impact Investing Rating System (“GIIRS”).

D. Laws Relating to Social

Venture Funds Investing into India Offshore social

venture funds tend to pool capital (and grants)

outside India and make investments in India like

a typical venture capital fund. Such Offshore Fund

may not directly make grants to otherwise eligible

Indian opportunities, since that may require

regulatory approval.

Onshore social venture funds may be registered as

a Category I AIF under the specific sub- category of




57

social venture funds. In addition to the requirement

to fulfill the conditions set out in the definition

(set out above), social venture funds under the AIF

Regulations are subject to the following specific

restrictions and conditions:

§ Requirement to have at least 75% of their

investible funds invested in unlisted securities or

partnership interest of ‘social ventures’68;

§ the amount of grant that may be accepted by

the fund from any person shall not be less than

twenty-five lakh rupees

§ Allowed to receive grants (in so far as they

conform to the above investment restriction)

and provide grants. Relevant disclosure in

the placement memorandum of the fund will

have to be provided if the social venture fund

is considering providing grants as well; and

Allowed to receive muted returns.

II. Media Funds

A. Media Funds – An Introduction

A media fund seeks to provide select sophisticated

investors with an opportunity to participate in

the financing of a portfolio of content, e.g., motion

pictures and televisions serials.

In current times, when demand for high quality films

and media products has increased, such pooling

platforms play the role of providing organized

financing to various independent projects or work

alongside studios and production houses. A unique

feature is the multiple roles and level of involvement

that the fund manager can undertake for the fund and

its various projects.

B. Media Funding Models

Most film funds take a ‘slate financing’ approach

wherein the investment is made in a portfolio of

films / media projects, as opposed to a specific

project. However, as a variation, investors can even

be introduced at the project specific level i.e. for a

single production only.

In terms of risk mitigation, the slate financing model

works better than a specific project model owing to

risk-diversification achieved for the investor.

Apart from typical equity investments, film funds

may additionally seek debt financing pursuant to

credit facilities subject to compliance with local laws

e.g., in the Indian context, debt financing by Offshore

Fund may not work.

C. Risks and Mitigating Factors

Film fund investors should take note of media industry

specific risks such as - risk of abandonment of the

project (execution risks), failure to obtain distributors

for a particular project, increased dependence on key

artists, increasing marketing costs, oversupply of

similar products in the market, piracy, etc.

To mitigate such risks, diversification in the projects

could be maintained. Additionally, a strong and reliable

green lighting mechanism could also be put in place

whereby the key management of the fund decides

the projects that should be green lit – based on factors

such as budgeted costs, available distributorship

arrangements, sales estimates and so on.

D. Life cycle of a Film Fund

The life of a film fund in term of economic

performance is generally in the range of 8 to 10 years

depending upon the sources of revenue. Typically,

sources of revenue of a film are –

a. Domestic and international theatrical release of

the film;

b. Domestic and international television markets;

and

c. Merchandizing of film related products, sound

track releases, home video releases, release of

the film on mobile platforms, and other such

online platforms.

Generally, a major portion of income from a film

project is expected to be earned at the time of

theatrical release of the film, or prior to release

(through pre-sales). Consequently, the timing of

revenue is generally fixed or more easily determinable



58

in case of film investments, when compared to other

asset classes.

The box office proceeds of a film typically tend to be

the highest source of revenue and also a key indicator

of expected revenue from other streams. Thus,

keeping the timing of revenue flows in mind, film

funds are often structured as close ended funds having

a limited fund life of 7 to 9 years. The term may vary

depending on the number of projects intended to be

green lit or the slate of motion pictures or other media

projects intended to be produced.

Typically, after the end of the life of the fund, all

rights connected with the movie (including derivative

rights) are sold or alternatively transferred to the

service company or the fund manager on an arm’s

length basis. Derivative rights including rights in and

to prequels, sequels, remakes, live stage productions,

television programs, etc. may also be retained by

the investment manager (also possibly playing the

role of the producer). Such transfer or assignment of

residual rights is of course subject to the nature of and

the extent of the right possessed by the fund or the

concerned project specific SPV.

E. Sources of income of a film fund and tax treatment

i. Distributorship Arrangements

The fund or the project specific SPV, as the case may be,

may license each project to major distributors across

territories in accordance with distribution agreements.

Pursuant to such distribution agreements, the fund

could expect to receive net receipts earned from the

distributions less a distribution fee payable to the

distributor (which typically consists of distribution

costs and a percentage of net receipts). Income of this

nature should generally be regarded as royalty income.

If the distributor is in a different jurisdiction, there is

generally a withholding tax at the distributor level.

The rate of tax depends on the DTAA between the

countries where the distributor is located, and where

the fund / its project specific SPV is located.

ii. Lock Stock and Barrel Sale

The project exploitation rights may be sold outright

on a profit margin for a fixed period or in perpetuity

(complete ownership). This amounts to the project

specific SPV selling all its interest in the IP of the

movie for a lump sum consideration.

iii. Use of an Appropriate Intermediary Jurisdiction

Fund vehicles have historically been located in

investor friendly and tax neutral jurisdictions. The

unique nature of film funds adds another dimension

i.e. intellectual property (“IP”) while choosing an

appropriate jurisdiction. Generally, an IP friendly

jurisdiction is chosen for housing the intellectual

property of the fund or specific project. Further, since

considerable amount of income earned by the fund

may be in the form of royalties, a jurisdiction that

has a favourable royalty clause in its DTAA with the

country of the distributor may be used. This assumes

greater importance because the royalty withholding

tax rate under the ITA is 25%.

Due to its protective regime towards IP, low tax rates

and extensive treaty network, Ireland has been a

preferred jurisdiction for holding media related IP.

F. Role of Services Company

In a film fund structure, certain acquisition,

development, production and related services may be

performed by a separate entity (“Services Company”).

The Services Company may have a contractual

relationship with the fund or its project specific

subsidiaries, during the term of the fund. Depending

upon circumstances of each project, the fund may

engage the Services Company directly or through

a special purpose subsidiary to provide production

services. In respect of these services, the Services

Company receives a fee which can be included within

the fund’s operational costs. The role of the Services

Company / fund may also be fulfilled by the fund

manager. The Services Company / manager may also

hold the intellectual property associated with each

project that may be licensed to or acquired by the

fund or its project specific subsidiaries.




59

G. Role of the Fund Manager

The fund manager may take up the responsibilities

of the Service Company as indicated above. Once

a specific project is selected and green-lit by the

manager, all underlying rights necessary to produce

and / or exploit the project may be transferred to the

fund. In addition to such role, the manager would

also be expected to play the role of the traditional

manager of a pooled investment vehicle and expected

to discharge its fiduciary obligations. To an extent,

the same may require observing specific ‘conflict

of interest’ mechanisms considering the multiple

functions that may be performed in the context of a

film fund.



60

Annexure II

Summary of Tax Treatment for Mauritius and Singapore Based Entities Participating in Indian Opportunities

The following table summarizes the (i) requirements for eligibility under the India- Mauritius DTAA and the

India-Singapore DTAA; (ii) the substance requirements that companies in Mauritius and Singapore will have to

demonstrate in order to claim benefits under the two DTAAs and (iii) the tax rates that should be applicable to

companies under the relevant DTAAs read with the provisions of the domestic tax law.

Parameter Mauritius Singapore

General

Eligibility to DTAA benefits

A person is considered a resident of Mauritius for relief under the DTAA, as long as it is liable to tax in Mauritius by reason of domicile, residence or place of management. The Indian tax authorities issued a Circular (789 of 2000) stating that a tax residency certificate (TRC) issued by the Mauritius tax authorities constitutes sufficient proof of residence in Mauritius and entitlement to DTAA relief.

The landmark decision of the Indian Supreme Court in Union of India v. Azadi Bachao Andolan,63 upheld the validity of the aforesaid Circular 789. Following this case, a number of cases have confirmed DTAA benefits for Mauritius based investors including: Dynamic India Fund I64; DDIT v. Saraswati Holdings Corporation65; In re, E*Trade Mauritius Limited66; In re, Castleton Investment Ltd67; Zaheer Mauritius v. DIT68 D.B.Zwirn Mauritius Trading69; HSBC Bank (Mauritius) Ltd. v. DCIT.70

However, certain Courts have also taken contrary views specifically challenging the beneficial ownership of shares of the Indian company by the Mauritian taxpayer and alleging that the transaction of acquisition of shares of Indian company was a colourable device and an impermissible tax avoidance arrangement for deriving DTAA benefit.71 With the revision of the India-Mauritius DTAA, and introduction of

The management and control of business of the pooling vehicle must be in Singapore. Tax resident companies are eligible for DTAA benefits subject to (as a practical matter) being able to obtain a tax residency certificate from the Inland Revenue Authority of Singapore.

63. [2003] 263 IT 707 (SC)

64. AAR 1016/2010 dated July 19, 2012

65. [2009] 111 TTJ 334

66. [2010] 324 ITR 1 (AAR)

67. [2012] 348 ITR 537

68. [2014] 270 CTR (Del) 244

69. [1997] 228 ITR 268

70. [2018] 96 taxmann.com 544 (Mumbai - Trib.)

71. “AB” Mauritius, In re AAR No. 1128 of 2011




61

anti-abuse rules, courts in India have also been challenging the availability of treaty benefits for investments dating prior to April 1, 2017. Recently, the Mumbai bench of the Authority for Advance Rulings in Bidvest72 rejected capital gains tax benefit under Article 13(4) of the India–Mauritius DTAA to a Mauritian entity, on sale of shares of an Indian joint venture company.

Substance Requirements

The GBC would be required to carry out the core income generating activities: (i) employing, either directly or indirectly, a reasonable number of suitably qualified persons to carry out the core activities; and (ii) having a minimum level of expenditure, which is proportionate to its level of activities. Further, while determining whether the activities constitute as core income generating activities, the FSC will take into consideration the nature and level of core income generating activities conducted (including the use of technology) by the GBC.

Under the Protocol, India shall tax capital gains arising from the sale of shares acquired on or after April 01, 2017 in a company resident in India with effect from financial year 2017-18.

The India-Singapore DTAA itself states the Substance requirement. Subsequently negotiated protocol to the India-Singapore DTAA requires that the Singapore entity must not be a shell or a conduit entity. A shell / conduit entity is the one which has negligible or nil business operations or has no real and continuous business activities that are being carried out in Singapore. A Singapore resident is deemed not to be a shell or conduit if it is listed on a recognized stock exchange or if its annual operational expenditure is at least SGD 200,000 per year in the two years preceding to the transfer of shares which are giving rise to capital gains. (The term “annual expenditure” means expenditure incurred during a period of twelve months. The period of twenty-four months shall be calculated by referring to two blocks of twelve months immediately preceding the date when the gains arise.)

Accordingly, if the affairs of the Singapore entity are arranged with the primary purpose of taking benefit of capital gains relief, the benefit may be denied even if the Singapore entity is considered to have commercial substance under the GAAR provisions or incurs annual operational expenditure of SGD 200,000.

MLI Mauritius has not included India in its definitive notification, accordingly, India-Mauritius DTAA is not considered a CTA.

In case Mauritius notifies India-Mauritius DTAA as CTA, there would be a significant change in tax positions from investments made through the Mauritius route.73

India-Singapore DTAA notified as CTA.

Preamble of India-Singapore DTAA modified to include clear statement of intent.

LoB contained in Article 24A superseded by PPT, which will need to be satisfied to avail benefits.74

Tax Implications under the Relevant DTAA

Dividends Taxable at rate of 5%, if Mauritian shareholder is beneficial owner holding directly at least 10% share capital of Indian company; otherwise 10%.75

Taxable at rate of 10%, if the Singaporean shareholder is a company being beneficial owner of at least 25% share capital of Indian company; otherwise 15%.76

72. In Re: Bid Services Division (Mauritius) Ltd. 2020 (2) TMI 1183

73. From news reports, it appears that India and Mauritius may bilaterally re-negotiate the India-Mauritius DTAA to adopt the minimum standards emanating from the MLI;

https://www.business-standard.com/article/markets/talks-on-to-adopt-beps-minimum-standards-in-tax-treaty-mauritius-minister-120051800772_1.html

74. The other specific tests under the LoB in Article 24A of the India-Singapore DTAA relating to shell / conduit companies not being entitled to benefits, minimum expenditure requirements etc. will continue to be applicable as they are not incompatible with the PPT.

75. Article 10(2) of India-Mauritius DTAA.

76. Article 10(2) of India-Singapore DTAA.

https://www.business-standard.com/article/markets/talks-on-to-adopt-beps-minimum-standards-in-tax-treaty-mauritius-minister-120051800772_1.html



62

Capital Gains No local tax in Mauritius on capital gains.

Till April 1, 2017, Mauritius residents were not taxed in India on gains resulting from the transfer of shares in an Indian company.

After April 1, 2017 post amendment of India-Mauritius DTAA:

i. No tax on capital gains on alienation of shares acquired by Mauritian residents before April 1, 2017.77

ii. 50% of applicable Indian tax rate on capital gains arising to Mauritian residents from alienation of shares between April 1, 2017 to April 1, 2019, subject to PPT and LoB rule.78

The LoB rule states that a shell / conduit company79 shall not be entitled to the concessional tax rate under Article 13(3B).

iii. Capital gains arising on alienation of shares acquired by Mauritian residents after April 1, 2019 taxable in India.80

No local tax in Singapore on capital gains (unless characterized as business income).

Till April 1, 2017, Singapore residents were not taxed in India on gains resulting from the transfer of shares in an Indian company.

After April 1, 2017 post amendment of India-Singapore DTAA:

i. No tax on capital gains on investments made by Singapore residents before April 1, 2017, subject to PPT and LoB rule.81

ii. 50% of applicable Indian tax rate on capital gains arising to Singapore residents from alienation of shares between April 1, 2017 to April 1, 2019, subject to PPT and LoB rule.82

The LoB rule states that a shell / conduit company83 shall not be entitled to the benefits under points i. and ii. above.

Capital gains arising on alienation of shares acquired by Singapore residents after April 1, 2019 taxable in India.84

Interest 7.5%, subject to satisfaction of beneficial ownership test.85

15%, subject to satisfaction of beneficial ownership test.86

Tax Implications if the non-resident investor is not eligible to claim benefits under the relevant DTAAs

Capital Gains Nature of securities Short-term capital gains Long-term capital gain

Sale of listed equity shares on the floor of the recognized stock exchange

(Securities Transaction Tax paid)

15% 10% without foreign exchange fluctuation benefit (capital gains in excess of INR 0.1 million)

Sale of other listed securities 40% 10% without indexation benefit

Sale of unlisted shares and securities 40% 10% without foreign exchange fluctuation benefit

77. Article 13(3A) of India-Mauritius DTAA.

78. Article 13(3B) read with Article 27A of India-Mauritius DTAA.

79. A shell /conduit company is defined to mean any legal entity falling within the definition of resident with negligible or nil business operations or with no real and continuous business activities carried out in that Contracting State. Article 27A of India-Mauritius DTAA also elaborates cases wherein an entity will be deemed or will not be deemed to be a shell / conduit company.


81. Article 13(4A) read with Article 24A of India-Singapore DTAA.

82. Article 13(4C) read with Article 24A of India-Singapore DTAA.

83. Article 24A of India-Singapore DTAA elaborates cases wherein an entity will be deemed or will not be deemed to be a shell / conduit company.

84. Article 13(4B) of India-Singapore DTAA.


86. Article 11(2)(b) of India-Singapore DTAA.



64

The following research papers and much more are available on our Knowledge Site: www.nishithdesai.com

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Technology and Tax SeriesPlatform Aggregators | Business Model Case Study

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65

Research @ NDAResearch is the DNA of NDA. In early 1980s, our firm emerged from an extensive, and then pioneering, research by Nishith M. Desai on the taxation of cross-border transactions. The research book written by him provided the foundation for our international tax practice. Since then, we have relied upon research to be the cornerstone of our practice development. Today, research is fully ingrained in the firm’s culture.

Our dedication to research has been instrumental in creating thought leadership in various areas of law and pub-lic policy. Through research, we develop intellectual capital and leverage it actively for both our clients and the development of our associates. We use research to discover new thinking, approaches, skills and reflections on ju-risprudence, and ultimately deliver superior value to our clients. Over time, we have embedded a culture and built processes of learning through research that give us a robust edge in providing best quality advices and services to our clients, to our fraternity and to the community at large.

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